Bank of England Policy Meeting

The 4–5 November meeting of the Bank of England's Monetary Policy Committee (MPC) could well end with a bang. It is a stone-dead certainty that interest rates will stay at 0.50%, but there could well be fireworks amid significant divisions within the MPC over whether to further extend the bank's quantitative easing (QE) program—and if so, by how much?

While a lot of uncertainty surrounds the accuracy of the preliminary national accounts data that show the U.K. economy unexpectedly contracted by 0.4% quarter-on-quarter (q/q) in the third quarter, we believe that the GDP fall tips the odds in favor of the Bank of England extending QE by a further £25 billion to £200 billion. Latest hard data indicating that bank lending remains muted further support suspicion that QE will be extended.

The minutes of the October MPC meeting revealed that the committee was unanimously and firmly in favor of sitting tight on QE as well as on interest rates ahead of the Bank of England's new GDP and inflation forecasts, which it will have available at the November meeting. There was also no pressing need for the MPC to decide on whether or not to extend QE in October given that the current £175-billion program of asset purchases would last until the November MPC meeting.

Indeed, the October minutes gave little real insight as to which way the MPC was leaning on a QE extension at its November meeting. The MPC considered that recent developments had been generally positive, with latest data and surveys pointing to some economic growth in the second half of the year. The MPC believed that the asset purchase program has had a positive impact on financial markets, through helping to reduce gilt yields and sterling LIBOR rates, as well as supporting sterling asset prices. The committee considered that liquidity conditions had improved in many financial markets and also believed that while corporate credit remained hard to access, "there was some evidence that credit conditions had recently eased."

Nevertheless, the October minutes indicated that the MPC by no means believes that the U.K. economy is out of the woods, and the committee clearly continues to have serious worries about the strength and sustainability of the upturn, particularly given the ongoing need and desire for financial institutions, households, and companies to improve their balance sheets. The MPC also has significant concerns about the durability of the global recovery.

Meanwhile, the MPC considered that inflation was likely to be volatile in the near term because of base effects and changes in the value-added tax (VAT) rate. The MPC believed that this near-term volatility in inflation was unlikely to change the longer-term outlook, though, unless it led to significant changes in inflation expectations. The MPC essentially still appeared to believe that consumer price inflation is likely to be held down to be around its 2.0% target level on a two-year horizon due to the substantial spare capacity in the economy and high unemployment, coupled with likely gradual recovery.

Interestingly, the October MPC minutes reported that "there were differences of view among members of the Committee on the balance of risks to the medium-term outlook for inflation and how it had shifted in recent months." This suggests that sparks may fly at the November meeting over whether to extend QE.

Probably the key development since the October MPC meeting has been the news that U.K. GDP contracted by 0.4% q/q in the third quarter. This is highly likely to have surprised all the MPC members. Indeed, the minutes of the October meeting clearly indicated that the MPC expected the economy to have grown in the third quarter. Specifically, the minutes commented that "domestically, the combination of the latest official data and the most recent surveys suggested that the level of output in the third quarter was likely to be close to the central projection in the August Inflation Report." This central projection put GDP at -4.6% year-on-year (y/y) in the third quarter, which was significantly higher than the actual outturn of -5.2%. Without allowing for revisions to the back data, this implied growth of 0.2% q/q in the second quarter.

Even allowing for widespread skepticism that the economy really did contract by 0.4% q/q in the third quarter, we suspect that the majority of MPC members will decide that a £25-billion extension of the QE program to £200 billion is warranted, to give the recovery a further helping hand. Still-weak bank lending reinforces the case for more QE.

Indeed, it is not inconceivable that the MPC could decide next Thursday that a further £50 billion of QE is justified, taking the total up to £225 billion. However, we suspect that most MPC members will be reluctant to go this far for now at least, particularly as a further £25 billion would be sufficient for the QE program to last through to February and give the MPC time to see whether the economy is finally growing again. Indeed, we lean toward the view that £200 billion will prove to be the ceiling for QE, unless the economy fails to start growing in the fourth quarter or suffers a major relapse in 2010.

Meanwhile, interest rates look ever more likely to stay down at 0.50% until at least late 2010. Indeed, any rate hikes could well be delayed until 2011.

Main Economic Releases

Manufacturing data and surveys are very much to the fore during the coming week. Significant improvement will be hoped for. It would offer reassurance that the sector is not suffering a renewed serious downward lurch. Moreover, it would convey that the 2.5% month-on-month (m/m) plunge in industrial production in August really was primarily due to a significant number of firms deciding it was most economical to completely shut down for a holiday period over the summer and allow stock levels to be depleted further. Industrial production was further dragged down in August by oil and gas output being limited by maintenance work in the North Sea. We expect industrial production (Thursday) to have grown by 0.9% m/m in September, thereby causing the y/y decline to narrow to 10.5% from 11.2% in August. Within this, manufacturing output is forecasted to have grown by 0.7% m/m in September, with the y/y drop moderating to 10.0%, from 11.3% in August.

In addition, the manufacturing purchasing managers' index survey (PMI; out on Monday) is forecasted to show overall activity in the sector expanded modestly in October after marginal contraction in both September and August. Specifically, we forecast the PMI to rise to 50.2 in October from 49.5 in September, taking it just above the critical 50.0 level that indicates expanding activity. Despite the PMI being below 50.0 in September, the survey still indicated that output and new orders expanded modestly for a third successive month. The Confederation of British Industry (CBI) has already released its industrial trends survey for October, which showed overall improvement.

While question marks remain over the longer-term outlook for manufacturing, companies should benefit in the near term at least from sharply reduced stock levels, as well as from the weak pound, not only helping exporters but also making U.K. manufacturers more competitive in their domestic markets. On top of this, demand has been showing signs of picking up at least temporarily in important overseas markets (notably the Eurozone and the United States) as well as at home.

Producer price data for October (Friday) should indicate that manufacturers' pricing power is pretty limited because of substantial excess capacity and intense competition. Furthermore, demand is clearly still far from robust. Specifically, we forecast producer output prices to have risen by a modest 0.2% m/m in October. Nevertheless, the y/y increase in producer output prices is expected to spike from 0.4% in September to 1.7% in October because of unfavorable base effects resulting from the sharp monthly drops in producer prices from August 2008 as oil prices fell substantially from their July 2008 peak levels. Core output producer prices are also expected to have risen by 0.2% m/m in October; this would cause the y/y increase to rise to 2.0% from 1.4% in September. Meanwhile, the consensus is for producer input prices to have risen by 1.5% m/m in October, primarily because of oil prices being stronger than in September. Sterling's weakness may also have pushed input prices up. The y/y fall in producer input prices is seen narrowing sharply to 1.3% in October from 6.5% in September and 12.2% in July. This also reflects the fact that input prices fell sharply from August 2008 as oil prices retreated from their July 2008 record high.

The construction PMI (Tuesday) is likely to show that the sector is still contracting appreciably, albeit at a much-reduced rate compared with its level earlier this year. We expect the PMI to come in at 46.5, which would be little changed from the September level of 46.7. Indeed, this would be the fourth successive reading around this level, which is well up from February's low but still clearly below the 50.0 level that indicates unchanged activity.

The construction sector is being helped to a limited extent by the government bringing forward some infrastructure spending as part of its efforts to boost the economy, while recent modestly, but steadily rising housing market activity—and increased optimism about the outlook—has helped house building activity lift off its lows. Even so, serious concerns remain about the outlook for the construction sector, with the housing market and commercial property sectors still facing significant problems. The preliminary national accounts data for the third quarter showed construction output contracting by 1.1% q/q following drops of 0.8% in the second quarter and 6.9% in the first.

It is hard to know what to say about the service sector PMI for October (Wednesday). The September business activity index climbed to a two-year high of 55.5, which indicated clear expansion. This was the fifth month running that the index had been above the 50.0 level that indicates unchanged activity. Furthermore, other elements of the survey in September were largely encouraging. New business expanded for the fourth time in five months, and at the fastest rate since February 2008, while business expectations in the sector climbed to a 29-month high.

It appeared that firming business and financial activity was lifting services, while it was also being helped by housing market activity picking up to a limited extent from the lows seen around the turn of the year. In addition, there were indications that consumer spending on services may have bottomed out. Yet the preliminary third-quarter national accounts showed service sector output contracting by a further 0.2% q/q, which appears very much at odds with the picture portrayed by the service sector PMI. We anticipate that the index will come in at 55.5 in October, which would be very similar to the September two-year high.

The Halifax lender is forecasted to report during the week that house prices rose by 0.6% m/m in October, which would be a fourth successive increase but down appreciably from a rise of 1.6% in September. Consequently, the y/y fall in house prices is expected to moderate to 4.8% in the three months to October from 7.4% in the three months to September and a peak of 17.7% in the three months to April. The y/y fall is seen slowing to 2.0% in October itself from 4.8% in September. The Nationwide lender has already reported that house prices rose by 0.4% m/m in October, which caused them to be up by 2.0% y/y (which was the first annual rise on the Nationwide's measure since March 2008).

While housing market activity has been lifted by the still-significant fall in house prices from their 2007 peak levels and low mortgage interest rates, the upside continues to be limited by unfavorable economic fundamentals (notably high and rising unemployment and low and slowing earnings growth) and tight credit conditions. We suspect that still relatively low housing market activity means that the firming in housing prices seen since March/April will fizzle out. This is even more likely to occur if more properties come on to the market, as a shortage of properties has been a key factor supporting house prices in recent months.

2 Nov - Manufacturing Purchasing Managers Index, October: 50.2
3 Nov - Construction Purchasing Managers Index, October: 46.5
4 Nov - Service Sector Purchasing Managers Index, October: 55.5
5 Nov - Industrial Production, September (Month-on-Month): +0.9%
5 Nov - Industrial Production, September (Year-on-Year): -10.5%
5 Nov - Manufacturing Output, September (Month-on-Month): +0.7%
5 Nov - Manufacturing Output, September (Year-on-Year): -10.0%
6 Nov - Producer Price Output Inflation, October NSA (Month-on-Month): +0.2%
6 Nov - Producer Price Output Inflation, October NSA (Year-on-Year): +1.7%
6 Nov - Core Producer Price Output Inflation (ex Food, Tobacco etc.) October SA (Month-on-Month): +0.2%
6 Nov - Core Producer Price Output Inflation (ex Food, Tobacco etc.) October SA (Month-on-Month): +2.0%
During Week - Halifax House Prices, October (Month-on-Month): +0.6%
During Week - Halifax House Prices, October (Year-on-Year): -4.8