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UK Economics2 March 2012

Important disclosures can be found on the last page of this publication.

Analysts

Richard Barwell

UK Economics

+44 207 085 5361

[email protected]

Gareth Anderson

UK economics

+44 207 085 2999

[email protected]

www.rbsm.com/strategy

Bloomberg: RBSR

How much would it take to geta significant minority of MPC

members voting for a BankRate hike by August?

Answer: not that much.

In a recent note we argued that the outlook for policy is particularly uncertain at the

current juncture because the risks are unusually large and the presence of positive

feedback effects will help to amplify any initial disturbance. In this note we illustrate

the fragility of the current policy equilibrium by arguing that it is not difficult to see asignificant minority of MPC members voting for a hike in Bank Rate in August 2012,

given recent MPC communication and the risks on the horizon.

We believe that the current policy equilibrium is unstable because the risks on thehorizon are so large and the presence of positive feedback will tend to amplify anyinitial disturbance. In this note we illustrate one example of how the current stanceof monetary policy could very quickly unravel.

The text of the February MPC minutes suggests to us that some members of the

MPC were reluctant converts to the decision to extend the stock of assetpurchases by 50 billion, given that some members saw a case for leaving policyon hold.

Should those reluctant members decide that the extension of QE2 wasunwarranted and needs to be reversed that would leave them in the position ofvoting for a 25 or even 50 basis point hike in Bank Rate.

There are three obvious economic triggers for a change of heart: rising energyprices which could ultimately de-rail the downward trend in inflation; the continuedmarked improvement in the situation on the Continent; and further evidence in thedemand and output indicators that the domestic economy is more resilient than firstthought.

Based on recent comments by MPC members we believe that Spencer Dale andMartin Weale both fall into this category of members who could be easilypersuaded to vote for a hike, with Paul Tucker not too far behind and potentiallyeven Charlie Bean.

To be clear, we are not forecasting that four members of the Committee will bevoting for a hike in Bank Rate as early as August. But we are trying to flag thehuge uncertainty around the outlook for policy.


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In a recent note we argued that the outlook for policy is particularly uncertain at the

current juncture because the risks are unusually large and the presence of positive

feedback effects will help to amplify any initial disturbance (Something has got to give

Why policy in the UK is in an unstable equilibrium).

In this note we illustrate the fragility of the current policy equilibrium by arguing that it is

not difficult to see a significant minority of MPC members voting for a hike in Bank Rate

in August 2012. Given that market prices at the time of the February Reportsuggested

that the first hike was not fully priced in until August 2014 that would appear to us to be

a material shift in policy. Our arguments are as follows.

Ancient history: the vote for QE2 in October

One of us was surprised by the timing of the launch of QE2 not because looser

monetary policy did not seem to be the right response to the outlook but because the

votes and commentary of many MPC members in the run up to the October decision

did not seem consistent with a vote to extend the asset purchase programme at that

particular meeting. Indeed, Adam Posen used the word disturbing to describe the

abrupt change in the pattern of votes on the Committee:

'We went from an 8-1 vote against to 9-0 for, not because the committeesuddenly decided the world was ending. I don't know what thedifferences in the process should be but it seems to me...Maybe thecommittee would have gone from 1-8 to 2-7 to 3-6 to 4-5.I do not knowwhy it didn't turn out that way.

Adam Posen had been consistently advocating a 50 billion extension in asset

purchases for some time. He changed his mind over the optimal stance of monetary

policy by 25 billion between September and October in response to the deterioration in

the outlook. In contrast, the others moved by 75 billion within a month (although to be

fair they had been edging towards an extension) and in the case of Weale and Dale,

members went from voting for a hike in July to agreeing with Posen on the scale of the

increase in asset purchases in October. That amounted to a 100 basis point change in

the optimal stance of policy in three months.

There are two interpretations of this outcome. Either Weale and Dale thought that the

developments between July and October warranted a larger change in the stance of

policy than the others and Posen in particular which might be the case if the

Committee came round to Posens way of thinking on the economy, and Dale and

Weale more than the others. Or Weale and Dale went along with the majority

preference over the size of asset purchases because it was believed that presenting a

united front was important to backstop confidence. We do not rule out the second

argument, so therefore believe there could be reluctant converts to the stock of asset

purchases within the Committee, although it has to be said that Weale and Dale have

gone along with the consensus since then.

The February extension to QE2

The Minutes of the February policy meeting only added to our sense that some MPC

members are a little uncomfortable with the direction of monetary policy. Some MPC

members outlined a case for keeping policy on hold in that meeting, and yet the only

dissent against the majority decision to extend the programme by 50 billion came from

Posen and Miles who preferred 75 billion.

As we outlined in a recent piece ('25 bn. is neither here nor there': The MPC appears to

have an aversion to a 25 billion increase in its asset purchase programme ) it is strange

that those MPC members who saw a case for zero did not even make the case for a 25

billion extension in QE. We find it hard to believe that hawkish MPC members still

think that it is important to show a united front given Miles and Posen dissented onother side. Equally, we find it hard to believe that the Minutes would include a

How much would it take to get a significant minority of MPC members voting for a Bank Rate hike by August?

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reference to an argument for leaving policy on hold if no MPC member seriously

entertained that proposition. Non-monotone preferences over the stock of asset

purchases are equally unlikely. We therefore conclude that at least some MPC

members believe that a 25 billion extension in the programme was not an option -

presumably because it would have had too trivial a macroeconomic impact to be worth

bothering with.

We are not sure whyMPC members would have reached that conclusion given their

belief that a 25 billion extension is more or less equivalent to a bog standard Bank Rate

cut of 25 basis points. But the important point is that for some MPC members it was a

close call between voting for a 50 billion extension and doing nothing at all. In other

words, February was a clearer case of reluctant converts to the current stance of policy.

What hawkish dissent would look like

Should an MPC member come to the conclusion that the full 50 billion extension was

not warranted in the March meeting then it is possible that his desired policy setting

could be achieved by voting for a much smaller increase in asset purchases from that

point on. But by April and certainly by May the die is cast. At that stage a belief that

the 50 billion extension was over-done and has to be reversed translates into a vote for

a Bank Rate hike given the Committees oft-stated rule that Bank Rate hikes come firstand asset sales later when it comes to tightening policy.

In particular, given the Committees stated views on the relative macroeconomic impact

of asset purchases and changes in interest rates, if a Committee member decided that

half of the 50 billion increase in February needs to be reversed that would translate into

a vote for a 25 basis point hike in Bank Rate. A member who believed that the whole

February extension needs to be unwound (i.e., policy should have been left on hold in

February) ought to vote for a 50 basis point hike in Bank Rate.

Some will argue that practical central bankers would never change their position this

abruptly. We cannot ignore the fact that economists include the lagged policy decision

in the Taylor Rule for a reason. But the changes in the votes of some membersbetween July and October 2011 illustrate that one cannot rely on the fact that members

views will always change at a glacial pace.

Is there any evidence that MPC members might change their minds?

It is all very well to argue that the current pattern of votes on the Committee is fragile.

But in order to seriously entertain the proposition that several MPC members might

vote for Bank Rate hikes in the near future we need to provide some evidence that

something will happen to change their minds.

Economics news: oil, Europe and domestic activity

We can identify three potential triggers for a change of heart among certain Committeemembers: rising energy prices, further improvement in Europe and a more resilient

domestic economy.

The price of oil has increased by around 10% over the past month. Rising energy

prices influence consumer prices through numerous channels as we outlined in The

macroeconomics of rising energy prices. In a recent note we argued that the first round

impact of a 10% increase in oil and gas prices through the supply chain puts 0.36% on

the level of consumer prices, with two thirds of that impact coming through utility bills

(Will oil prices arrest the downward trend in inflation?). Given the sensitivities around

the Committees forecast that inflation will fall below the target in 2013, this increase in

oil prices though not yet sufficient to de-rail the downward trend in inflation is

already meaningful. Some MPC members indeed the majority may argue that the

Committees remit allows them to look through these first round effects on inflation, as


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the Committee did in 2011. We would agree with that assessment. But it is important

to stress that not every Committee member felt and voted that way in 2011. Further

increases in energy prices and in particular wholesale gas prices which drive our first

round effects through utility bills could make some MPC members very nervous. This

is the negative global supply shock scenario we outlined in Something has got to give

Why policy in the UK is in an unstable equilibrium.

A major factor driving the majority of Committee members into voting for QE2 was the

deteriorating situation in Europe, which was infecting the UK economy through thetrade and confidence channels but most importantly through the UK banks exposure to

Europe. There has been a profound improvement in the situation on the Continent

since late last year. The front end of the Spanish government bond yield curve has

rallied from in excess of 6% to close to 2%. On the real economy front, the euro-zone

is likely to be in a mild rather than deep recession in Q1. If the situation continues to

improve that will continue to lift both the modal outlook for the UK and reduce the

downside risks. In passing it will also likely put upwards pressure on energy prices, via

the implied impact on global demand. This is not to say that the European crisis has

been resolved as we argued in Something has got to give Why policy in the UK is in

an unstable equilibrium that would imply a profound shift in the stance of policy but

simply a continued gradual improvement could lead to increased discomfort among the

more hawkish members of the Committee, which up to now has seemed quitedownbeat on the improvement in Europe.

The other big question confronting the MPC is whether the weakness in activity in Q4

was a transient soft patch or the beginning of a more sustained period of weakness. In

the past couple of months it is noteworthy that at least some of the demand and output

indicators have been printing in pretty healthy territory. The PMI services indicator

reached 56.0 in January. Although we continue to believe this indicator gets too much

attention given its inability to track the official data outside the Great Recession

(Calibrating the risks to Q4 UK GDP from the services sector) it is clear that the MPC

does put a lot of faith in this indicator. But it is not just the PMIs that have been strong.

Retail sales have also been resilient. There may come a point where some MPC

members ask themselves whether the February extension in asset purchases was aclassic error of policymakers continuing to stimulate the economy at the point when the

recovery was already starting to take hold.

Read my lips

In the end we think that the best way to forecast an imminent change of direction by a

member of the Committee is to focus on what they have to say. And we think that there

are signs that several Committee members are far from committed converts to the

February extension in QE.

Although he has said relatively little recently, we suspect that Spencer Dale is one of

those Committee members who are more concerned about the medium-term inflation

outlook (on the upside) and the risk that sustained inflation overshoots could become

entrenched. In part this is based on his votes in the middle of 2011. But it also reflects

a comment in a speech he made at the end of 2011 in which he explicitly differentiated

himself from the median view of the Committee:

In the Inflation Report published last month, the best collective

judgement of the MPC was that inflation was likely to fall to below the 2%

target by the end of next year, with the balance of risks throughout 2013

weighted quite heavily towards inflation being below target. Although I

also expect inflation to continue to fall through 2012, my own view is that


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the chances of inflation being above or below the target by the end of

next year and into 2013 are a little more balanced.1

Experience in 2011 suggests that Martin Weale is not particularly comfortable with the

Bank of England strategy of accommodating the first round effects of oil prices,

accepting an inflation overshoot as a price worth paying to avoid further weakness in

demand. In a speech this week, Weale noted his concerns about the inflation outlook:

on a seasonally-adjusted basis, the monthly rate of inflation, which fellbelow a level compatible with the target at the end of last year, seems

likely to be higher than is consistent with the target in the first half of this

year. The price of oil is a particular worry. The further out we go, of

course, the more uncertain things become. Nevertheless, this does

suggest a risk that there may be more persistence to inflation than one

might expect at a time of rising unemployment and weak demand.

Further ahead, there remains a risk that an eventual return to more

normal economic conditions will be associated with increased wage

pressures. Judgements about the magnitude of this are inevitably

uncertain and it is hard to avoid the sense of an additional upside risk2

Weale made it clear that he does not think it is likely that there will be a case for afurther extension to QE. Moreover, he warned the market that Bank Rate hikes could

come earlier than is currently priced in the yield curve if the very real risks I see about

inflation do materialise, then it is perfectly possible that the first rise will come earlier

(than mid-2014). In an article in the Guardian in January 2011 Weale argued that a

small rise in interest rates now would cost us less in the long run than higher ingrained

inflation it would not be a huge shock if he were to write a similar letter at some point

in 2012.

We suspect that Paul Tucker may be vulnerable to a change of heart on policy too.

Tucker has consistently highlighted his concerns around the medium-term trajectory of

inflation and how that shapes his views on policy. For example, in late November he

argued that inflation is uncomfortably high, and an absolute precondition formaintaining our support to demand is the credibility of monetary policy.

3In his

testimony to the Treasury Select Committee, Tucker flagged some of the upside risks

to inflation from a more rapid pickup in wages if some people leave the labour force,

from the possibility of disruption to oil supply in Nigeria and Iran, and from a rebuilding

of profit margins once recovery appears more secure, not least from oil. Finally, one

would not want to ignore Tuckers warning about the perils of well intentioned ultra

loose monetary policy in his speech to the Society of Business Economists:

That stimulus can be sustained only so long as medium-term inflation

expectations remain anchored to our target of 2%. We must be alert to

the need gradually to withdraw stimulus as and when recovery builds.

And we must be alive to the possibility that the alleviation of currentmacroeconomic problems could sow the seeds, somewhere in the

financial firmament, of the next set of imbalances4

Beyond those three, we also think it is worth considering the position of Charlie Bean.

Like Paul Tucker we know Bean was considering a Bank Rate hike in early 2011. More

1Dale, S (2011), Prospects for monetary policy: learning the lessons from 2011, Speech given at Bloomberg.

2Weale, M (2012), From retailers paradise to shoppers strike: what lies behind the weakness in consumption?,

Speech given at the Cass Business School.

3Tucker, P (2011), A few remarks on current monetary policy in a rebalancing economy, Speech at The Joint

1900/City Club Lunch.

4Tucker, P (2012), National balance sheets and macro policy, Speech to the Society of Business Economists Annual

Dinner.


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recently and therefore more importantly we learn from his evidence to the Treasury

Select Committee that he is more concerned than the median member of the

Committee whose views are presumably reflected in the fan charts:

some uncertainty about the speed at which inflation will fall back afterthat. In large part, that depends on how productivity and labour marketslack evolve and how they impact on pay, as well as on whetherconsumer-facing firms seek to re-build squeezed profit margins. I am, ifanything, slightly north of the Committee's best collective judgement onthis.

Conclusions

We do not think a hike in Bank Rate is warranted at this juncture. We think Adam

Posen continues to plot the correct course through the headwinds buffeting the UK

economy. However, the task is to forecast what Committee members will do, and we

think that there are some reluctant converts to the current stance of monetary policy

who might be relatively easily persuaded that the latest increase in asset purchases

needs to be reversed. That would imply votes for 25 or 50 basis point increases in

Bank Rate by two, perhaps three and possibly even four members of the Committee in

August. We should reiterate this is not our modal forecast, but it is a risk worth taking

seriously.


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Recent research by Gareth Anderson and Richard Barwell

We deliberately focus our research on big picture issues which are (or soon will be)central to the macroeconomic debate, with a particular focus on monetary policy asopposed to documenting high frequency movements in the data. The list below gives aflavour of our recent research. To see all the research published by the team pleasesee https://strategy.rbsm.com/strategy/Europe/Economics/Global/default.aspx

Will oil prices arrest the downward trend in inflation?

We quantify the first round effects of rising oil and gas prices through the supply chain

using Input Output analysis. We find that a 10% increase in energy prices should put a

0.36% on the level of consumer prices.

Something has got to give-Why policy in the UK is in an unstable equilibrium

We emphasise that the chance of a big shift in policy over the next 12 months is

particularly elevated because the risks on the horizon are so big and because positive

feedback effects will amplify any initial change in direction.

'25 bn. is neither here nor there': The MPC appears to have an aversion to a 25 billion

increase in its asset purchase programme

We discuss why a 25 billion increase in the Asset Purchase Programme should have

been discussed in the February policy meeting, given that some members saw a case

for no change in policy. We infer that an increase in the stock of asset purchases on

this scale is therefore unlikely.

Is the UK's safe haven status on the slide? Why Moody's was right to fall out of love

with the UK as part of its Valentine's Day ratings massacre

We assess Moodys decision to put the UK on negative outlook, and re-iterate our view

that the UKs safe haven status is not warranted by fundamentals. The political

commitment to austerity cannot be treated as unconditional; nor is the central banks

inclination to buy government bonds.

They thought it was all Okun .... It could be now: The risk of a super-sized

unemployment response to further weakness in demand

Economists expected that the collapse in demand in the crisis would lead to a muchsharper increase in unemployment than actually materialised. If the muted increase inunemployment and the weakness of productivity are flip sides of the same hoarding

coin then there is a risk that further weakness in demand could lead companies to re-

assess headcount, triggering a disproportionately large shake-out in employment.

Robert Lucas, immodest interventions and QE counterfactuals: A comment on the

macro consequences of to QE or not to QE

This note discusses the likely macroeconomic implications of the Bank of Englands

asset purchase programme. We review the Banks research in this area, and argue

that whilst it probably overstates the impact of a marginal change in the stock of asset


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purchases it probably underestimates the macroeconomic benefit of the scheme as a

whole, because the counterfactual would have been dire.

Still feeling the pinch? Household saving and the echo effect of the disposable income

squeeze

Although it is widely believed that consumption should bounce back when the

disposable income squeeze runs its course, this note argues that households may have

chosen to run down savings or run up debt to support consumption in the face of that

squeeze. If and when households choose to repair the damage done to their balance

sheets, consumption will not keep pace with household income

The end of the line for the UK inflation myth

We estimate how much changes in the headline rate of VAT have contributed to

movements in headline inflation and the likely impact of the VAT base effects dropping

out of the year on year comparison will have on inflation going forward.

No margin left for error: How pessimistic revisions to supply leave the Chancellor

perilously close to breaking his rules

We explore why the downwards revisions to the level of potential supply in the Autumn

Statement have left the Chancellor with precious little room for manoeuvre on the fiscal

rules, and illustrate the fragile nature of the UKs so-called safe haven status.


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