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03/07/2010 | Bank of England Policy Meeting Heads the U.K. Economic Week Commencing 5 July

Howard Archer

The Bank of England's Monetary Policy Committee is expected to keep interest rates at 0.50% at the conclusion of its meeting next Thursday. Meanwhile, latest industrial production and key service sector surveys will give clues as to how well the recovery is holding up.

 

Bank of England Set to Keep Interest Rates at 0.50% Despite Sticky Inflation

With Andrew Sentance being the first Monetary Policy Committee (MPC) member to break ranks and vote for a 25-basis-point interest-rate hike in June, and the minutes of the June MPC meeting appearing modestly more hawkish overall, an element of doubt is now starting to creep into what the Bank of England will do on monetary policy. Nevertheless, the odds still strongly favor the Bank of England keeping interest rates at 0.50% at the conclusion of the July MPC meeting on Thursday. We still lean toward the view that the Bank of England will keep interest rates at 0.50% through the rest of 2010, before raising them only gradually in 2011.

Sentance has consistently been one of the more hawkish members of the MPC, and we just cannot see at least four more MPC members joining him in voting for higher interest rates in the near term at least (or three and Bank of England Governor Mervyn King casting a deciding vote as there are currently only eight MPC members rather than the usual nine). Recent comments by three other MPC members—Paul Fisher, Adam Posen, and David Miles—have indicated that they are not prepared to raise interest rates yet.

Admittedly, the minutes of the June MPC meeting revealed concern within the committee over the recent resilience of inflation in the United Kingdom and the rise in households' short-term inflation expectations. This reflected consumer price inflation still well above the Bank of England's 2.0% target measure in May, despite retreating to 3.4% from the April peak of 3.7%, while the Bank of England/GfK NOP survey showed a marked rise in consumers' inflation expectations for the next year (up to 3.3% in the May survey from 2.5% in the February one). The June minutes also revealed that there are clearly differences of opinion about how much spare capacity there is in the economy and how much this will hold down inflation over the longer term.

Nevertheless, the MPC minutes also noted that core inflation has fallen in the United States and Eurozone because of the impact of spare capacity, and some committee members expressed belief this would happen in the United Kingdom. There was also acknowledgement within the committee that problems in the Eurozone and fiscal consolidation efforts in the United Kingdom could hold back U.K. growth and inflation.

Since the June MPC meeting was held, Chancellor George Osborne has delivered his emergency budget, which certainly did not hold back on extra fiscal tightening. While the MPC was clearly expecting significant extra fiscal tightening to be announced, we believe that the scale of the measures set out will be sufficient to encourage most MPC members to remain in "wait and see" mode on inflation and growth and to hold off from raising interest rates in the near term at least.

Sentance has indicated that the extra fiscal tightening contained in the emergency budget will not deter him from voting again for an interest-rate hike.

Significantly, though, Fisher, Posen, and Miles have indicated in recent speeches and articles that they are not ready to vote for a hike yet. Fisher warned that tightening monetary policy prematurely would risk "stifling the nascent recovery." He also indicated his belief that consumer price inflation would recede over the coming months as temporary factors, including the past depreciation of sterling, waned and concluded that "it was sensible not to try and offset the recent rise in inflation by tightening policy."

Meanwhile, Posen concluded that the United Kingdom is "tentatively in the recovery state" and warned that it could fall back into recession. He also noted that fiscal austerity in the United Kingdom will hurt as it will in the Eurozone.

Both Posen and Fisher acknowledged that inflation had been higher than expected, and Posen did express his doubts that this could solely be attributed to the temporary factors of value-added tax (VAT) rises, sterling's past depreciation, and higher energy prices. He also noted the rise in inflation expectations. Meanwhile, although Fisher expressed his belief that inflation would fall because of the slack in the economy, he accepted that inflation could turn out higher than the Bank of England expected.

While Posen and Fisher both indicated that if inflation continued to surprise on the upside they would be prepared to vote for higher interest rates, neither of them seems to think that this is the right action now.

In addition, Miles, in an interview with the Daily Mail newspaper remarked that "my own judgment is that we haven't yet got to the point at which a tightening in monetary policy is the right thing to do." Although Miles remarked that inflation was currently "uncomfortably" above the target level, he noted that it is now moving down.

We also get the impression that Governor King is prepared to remain in "wait and see" mode, particularly given the accelerated fiscal tightening that has been introduced by the new coalition government. Specifically, in his 16 June Mansion House speech, King commented that "monetary policy must be set in the light of the fiscal tightening over the coming years." He went on to say, "I know there are those who worry that too rapid a fiscal consolidation will endanger recovery. But the steady reduction in the very large structural deficit over a period of a parliament cannot credibly be postponed indefinitely. If prospects for growth were to weaken, the outlook for inflation would probably be lower and monetary policy could then respond. I do, therefore, Chancellor welcome your commitment to put the [United Kingdom's] public finances on a sound footing. It is important that, in the medium term, national debt as a proportion of GDP returns to a declining path."

There is the possibility of a token interest-rate hike before the end of the year if inflation provides further upside surprises over the coming months. We still believe it more likely than not that the Bank of England will keep interest rates at 0.50% through 2010, given relatively muted recovery and serious threats to growth coming not only from the fiscal squeeze that will increasingly start to bite, but from the Eurozone crisis. The budget may well lead to increasing consumer and business caution even before some of the measures are imposed or take effect.

We had expected interest rates to start rising in February 2011, but this looks questionable with the economy already set to be hit by VAT rising from 17.5% to 20.0% in January 2011. So, the first increase may well be delayed until the second quarter. When interest rates do start to rise, the increases are likely to be very gradual and limited because of the need to keep monetary policy loose to counter the major fiscal squeeze. Specifically, we see interest rates only rising to 1.75% by the end of 2011.

Meanwhile, we expect the Bank of England to keep the stock of quantitative easing unchanged at £200 billion for the rest of 2010 and at least the first half of 2011 before starting to gradually reverse the process. King revealed in last week's Mansion House speech that when monetary policy does start to be tightened, interest-rate rises are likely to precede a gradual and orderly sale of assets in a reversal of the quantitative easing program.

Main U.K. Economic Releases

Service Sector Activity in June

The service sector purchasing managers' index (out Monday) is forecasted to indicate that activity expanded at a similar rate in June compared with May. Specifically, we expect the business activity index to have remained at 55.4. This would point to reasonable but hardly spectacular expansion, given that a reading of 50.0 indicates unchanged activity.

The service sector currently appears to be finding it difficult to really kick on. In their June survey, the Bank of England's regional agents reported that "business services turnover had risen further, primarily reflecting recovering demand for professional services." Even so, the agents also reported that "consumer services turnover had remained broadly flat in recent months."

Trade Deficit in May

The total trade deficit (Friday) is expected to have narrowed to £3.0 billion in May from £3.3 billion in April. This would be just below the average monthly deficit of £3.1 billion so far in 2010 but above the average monthly deficit of £2.7 billion in 2009. Within this, the visible trade deficit is forecasted to have shrunk to £7.1 billion in May from £7.3 billion in April. Again, this would be just below the average monthly deficit of £7.2 billion so far in 2010 but above the 2009 monthly average of £6.8 billion.

Net trade was again negative in the first quarter of 2010, as GDP growth was limited to 0.3% quarter-on-quarter. It has been hoped for some time that the trade deficit will narrow over the coming months as exports benefit increasingly from the combination of sterling's relative weakness and healthier domestic demand in key overseas markets.

Worryingly, there are growing concerns that U.K. exports could be hit significantly by slower growth in the Eurozone due to the region's sovereign debt crisis and the associated intensified tightening of fiscal policy in a number of countries. Furthermore, while the pound remains at generally competitive levels, it has recently hit a 19-month high against the euro. These concerns have been heightened by the export orders index in the June manufacturing purchasing mangers' survey falling sharply to a 10-month low in June and indicating only marginal growth.

Industrial Production in May

We expect manufacturing output (Thursday) to have expanded 0.4% month-on-month (m/m) in May, which would push year-on-year (y/y) growth up to 4.5%. Manufacturing output previously eased 0.4% m/m in April after surging 2.2% m/m in March. Overall industrial production should have expanded 0.4% m/m in May, which would lift y/y growth to 3.2%. Survey evidence for May from both the Confederation of British Industry and the manufacturing purchasing managers was robust, although there are signs in the June surveys that the rate of growth may have peaked in the second quarter.

Manufacturers benefited through the first half of 2010 from healthier demand both at home and overseas, improved competitiveness in both domestic and foreign markets stemming from the weak pound, and leaner stock levels. The key question is can manufacturers sustain healthy growth over the second half of the year and beyond, as inventory adjustment comes to an end, fiscal policy is tightened substantially, and the Eurozone faces serious problems?

Producer Prices in June

Producer price data (Friday) are likely to show that output prices rose at a reduced rate of 0.1% m/m in June. This would leave the annual rate of increase unchanged at 5.7%. Core output prices are also forecasted to have risen a modest 0.1% m/m in June, but because they fell sharply a year ago, this would still cause the y/y increase to climb to 5.1%.

The y/y increase in producer prices is being pushed up by much higher petroleum product prices compared with a year earlier and the fact that producer prices were particularly soft a year ago as companies faced severely limited demand. Nevertheless, it is apparent that manufacturers have looked to take advantage of improved activity to push through some price increases and support their margins in the face of recent markedly higher input costs. There are signs that manufacturers may be starting to find it more difficult to do this, which is what we would expect to be the case given significant excess capacity.

Meanwhile, pressure on manufacturers to raise their prices likely eased in June, with the consensus being for producer input prices to have edged down 0.2% m/m. This would cause the y/y increase to moderate to 10.3% from 11.2% in May.

House Prices in June

The Halifax lender is expected to report during the week that house prices were only flat m/m in June, following declines of 0.4% in May and 0.1% in April. This would cause the y/y increase in house prices to moderate to 6.7% in the three months to June from 6.9% in the three months to May. The Nationwide lender has already reported that house prices edged up just 0.1% m/m in June. This was down from increases of 0.5% in May and 1.1% in April. Consequently, the y/y rise in house prices moderated appreciably to 8.7% in June from 9.8% in May and 10.5% in April on the Nationwide measure.

We suspect that house prices will struggle to make significant gains over the coming months. Although it may have picked up modestly from its early-2010 lows, housing market activity remains well below long-term norms. The economic fundamentals of high unemployment, still-falling full-time employment, and low earnings growth are hardly ideal, a major fiscal squeeze is starting, credit conditions remain tight and house price/earnings ratios have moved back up.

Also very significantly, more properties are coming on the market, thereby moving the supply/demand balance more in favor of buyers. This is particularly relevant as a shortage of properties has been a key factor in the recovery in house prices from their early-2009 lows. Nevertheless, some support for house activity and prices will come from the stamp-duty holiday for the next two years for first-time buyers on all properties costing up to £250,000.

On balance, we believe that house prices are likely to be erratic over the coming months and at best will make very modest gains over the rest of the year. We would not be surprised if they were only flat overall through the rest of 2010.


5 Jul - Service Sector Purchasing Managers' Index, June: 55.4
8 Jul - Industrial Production, May (Month-on-Month): +0.4%
8 Jul - Industrial Production, May (Year-on-Year): +3.2%
8 Jul - Manufacturing Output, May (Month-on-Month): +0.4%
8 Jul - Manufacturing Output, May (Year-on-Year): +4.5%
9 Jul - Non-EU Visible Trade Balance, May (GBP/Month): -3.8
9 Jul - Visible Trade Balance, May (GBP/Month): -7.1
9 Jul - Total Trade Balance, May (GBP/Month): -3.0
9 Jul - Producer Price Output Inflation, June (Month-on-Month): +0.1%
9 Jul - Producer Price Output Inflation, June (Year-on-Year): +5.7%
9 Jul - Core Producer Price Output Inflation (ex Food, Tobacco etc.) June (Month-on-Month): +0.1%
9 Jul - Core Producer Price Output Inflation (ex Food, Tobacco etc.) June (Month-on-Month): +5.1%
During Week - Halifax House Prices, June (Month-on-Month): 0.0%
During Week - Halifax House Prices, June (3-Month/Year-on-Year): +6.7%

Global Insight (Reino Unido)

 


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