Summary

The outlook for interest rates has become a lot more uncertain. Unexpectedly robust GDP growth of 1.1% quarter-on-quarter in the second quarter has increased speculation that the Bank of England could raise interest rates before the end of 2010, particularly as inflation remains sticky and well-above target at 3.2% in June. An interest rate hike as soon as Thursday, however, still seems highly unlikely. Andrew Sentance will undoubtedly continue to press for an increase in interest rates, but we suspect that the majority of Monetary Policy Committee (MPC) members will choose to remain in "wait and see" mode so they can monitor how well U.K. economic activity holds up after the second quarter spike up in activity, how sticky inflation remains, and whether or not there is a significant, sustained spike up in inflation expectations.

What is likely, though, is that the spike up in GDP growth in the second quarter will have diluted the case for any near-term revival in Quantitative Easing, although the Bank of England is clearly still concerned about tight credit conditions. One thing that does look clear is that interest rates are likely to remain very low for a considerable time to come, regardless of when they first start to rise. Monetary policy will need to remain loose for an extended period to offset the impact of the major, sustained fiscal squeeze.

On balance, we think it is more likely than not that the Bank of England will keep interest rates down at 0.50% through the rest of 2010 and early 2011. We expect the first hike to 0.75% to come around mid 2011.

Analysis

The news that the U.K. economy grew by a much larger-than-expected 1.1% quarter-on-quarter in the second quarter promises to make the August meeting of the Bank of England's Monetary Policy Committee (MPC) a spiky affair. Furthermore, the committee will have the Bank of England's new GDP growth and inflation forecasts available. Adding to the mix of a very interesting looking meeting, Martin Weale takes up his position as the MPC's new boy bringing the committee back up to its full complement of nine members.

The minutes of the July MPC meeting revealed that the committee had discussed the case for both a modest easing and a modest tightening in monetary policy. This reflected concerns within the committee over both the growth and the inflation outlooks. In the end, seven of the eight MPC members attending the July meeting voted to keep interest rates unchanged at 0.50%, while Andrew Sentance repeated his June vote for a 25-basis-point hike to 0.75%. All eight MPC members voted to keep the stock of Quantitative Easing unchanged at £200 billion at the July meeting.

While Andrew Sentance clearly sees the spike up in U.K. GDP in the second quarter as supportive to his call for an immediate rise in interest rates, last Wednesday's testimonies of other MPC members to parliament's Treasury Committee suggested to us that they remain unconvinced of the case for tighter monetary policy for now at least, given still-serious risks to the sustainability of the recovery. There was still reference to the possibility of a further modest easing of monetary policy eventually being needed.

The indication is that while most members are encouraged by the sharp improvement in U.K. GDP growth in the second quarter, they are treating the performance with a considerable degree of caution and continue to have serious concerns about the outlook. In particular, there is still clear concern over the threat to the recovery coming from slowing global growth, still very poor credit conditions, and the fiscal squeeze that will increasingly start to bite.

While it is apparent that none of the MPC members are happy with recent inflation levels, it is also apparent that they still see downside as well as upside risks to the inflation outlook. Consumer price inflation has moderated from April's peak of 3.7% to stand at 3.2% in June, but this is still well above the Bank of England's 2.0% target level. It should be noted, however, that consumer price inflation excluding indirect taxes stood at 1.6% in June, which was down from a peak of 3.0% last November, while consumer price inflation at constant tax rates was down to 1.5% in June from 2.9% last November.

On the downside, the MPC sees a risk that money spending in the United Kingdom will remain weak with the economy operating below capacity and keep consumer price inflation under its 2.0% target level over the medium term.

On the upside is the risk that with consumer price inflation likely to remain above its 2.0% target through much of 2011 due to next January's VAT hike (from 17.5% to 20%), inflation expectations could become entrenched at a higher level, thereby making it harder to bring consumer price inflation back down to 2.0%. David Miles in particular, however, has expressed his belief that higher inflation expectations would be unlikely to fuel wage growth due to the slack in the labor market.

Meanwhile, there continues to be major uncertainties within the MPC over how much spare capacity there is in the economy and how much this will hold down inflation over the longer term. Overall, though, the MPC's central view at their July meeting was that "the margin of spare capacity was likely to bear down on inflation and bring it back to target in the medium term once the impact of temporary factors had worn off."

And it is also relevant that sterling has firmed recently, which reinforces belief that the upward pressure on inflation coming from past sterling weakness should increasingly wane.

Consequently, despite the spike up in GDP growth in the second quarter, Bank of England governor Mervyn King's statement to the Treasury Committee concluded that the central bank still faces a very difficult task in balancing the upside and downside risks to inflation.

We still believe it more likely than not that the Bank of England will keep interest rates down at 0.50% through the rest of 2010, given likely ongoing muted recovery in the face of significant headwinds, most notably including the fiscal squeeze that will increasingly start to bite, problems in the Eurozone, and slower global growth. June's emergency budget may lead to increasing consumer and business caution even before some of the measures are imposed or start to bite. Specifically, we forecast the first rise in interest rates to come around mid 2011, with rates only reaching 1.75% by the end of 2011.

MAIN ECONOMIC RELEASES

Manufacturing Output in June and Purchasing Managers' Survey for July

The manufacturing purchasing managers' survey (PMI—out on Monday) is expected to show that the sector saw healthy activity in July, although the rate of expansion is likely to have edged back for a second month running. Specifically, we forecast the PMI to have eased back to 57.2 in July from 57.5 in June and 58.0 in May, which was the highest level with April since September 1994. This would still be substantially above the critical 50.0 level that indicates unchanged activity. The Confederation of British Industry (CBI) has already released its industrial trends survey for July. This showed the order books balance rising to a 23-month high of -16% in July from -23% in June but also revealed that producers had become less optimistic about their production outlook for the next three months.

We expect manufacturing output (out on Thursday) to have expanded 0.4% month-on-month and 4.3% year-on-year in June. Manufacturing output grew 0.3% month-on-month in May. Overall industrial production is also expected to have expanded by 0.4% month-on-month in June, after growing 0.7% in May, which would result in year-on-year growth of 2.2%.

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, however, 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, the Eurozone faces serious problems, and global growth is likely slower.

Producer Prices in July

Producer price data (out Thursday) are likely to show that output prices rose by just 0.1% month-on-month in July, after dipping 0.3% in June. This would cause the annual rate of increase to ease to 5.0% in July, from 5.1% in June, and a peak of 5.9% in May. Core output prices are also forecasted to have risen by a modest 0.1% month-on-month in July after falling 0.3% in June. This would see the year-on-year increase to slow to 4.4% in July from 4.8% in June.

Manufacturers clearly took advantage of improved manufacturing activity to push though price increases in the early months of this year to support their margins in the face of rising costs. June's fall in producer prices after only a modest rise in May, however, suggests that manufacturers are now finding it increasingly difficult to raise their prices, which is not surprising given significant excess capacity. Furthermore, pressure on manufacturers to raise their prices has eased recently as input prices have fallen back after spiking up earlier this year. The consensus is for producer input prices to have fallen 0.5% month-on-month in July after dipping 0.2% in June. Even so, this would still leave input prices up by 11.2% year-on-year in July.

Construction Activity in July

The construction purchasing managers index (PMI—out on Tuesday) is likely to show that overall activity expanded—pretty strongly—for a fifth month running in July. Nevertheless, we suspect that the survey may indicate a modest easing in activity from the elevated second-quarter levels. We expect the PMI to have edged back to 57.5 in July, from 58.4 in June, and a 32-month high of 58.5 in May. The PMI is substantially above the critical 50.0 level that indicates unchanged activity, having been below it for 23 months up to and including February.

Not only have the recent purchasing managers' surveys been healthy, but the preliminary national accounts data for the second quarter show that construction output surged by 6.6% quarter-on-quarter, which was the best performance since 1963. This substantial rebound in construction output only partly reflected the fact that activity was held back in the first quarter by the arctic weather at the start of the year.

While construction now appears to be on the mend after suffering extended, deep contraction, the sector still faces a very challenging environment. In particular, it is likely to be hit significantly by the coalition government's need to rein in its spending for an extended period as this is clearly going to hit expenditure on infrastructure and public buildings. Indeed, the Financial Times reported recently that the construction industry reckoned that the government was cancelling about 700 school rebuilding projects planned over the coming four years. In addition, housing market activity has been weaker so far in 2010, prices are showing signs of softening, and the outlook for the sector is currently looking increasingly worrisome; so, it remains to be seen how this will impact on house building.

Service Sector Activity in July

The service sector purchasing managers' index (out on Wednesday) is forecast to indicate that activity expanded at a slightly faster rate in July compared with June. Specifically, we expect the business activity index to have edged up to 54.5 in July after slipping to a 10-month low of 54.4 in June. This would point to reasonable but hardly spectacular expansion, given that a reading of 50.0 indicates unchanged activity. The preliminary national accounts data for the second quarter indicated that services output expanded 0.9% quarter-on-quarter, which was the best performance since the first quarter of 2007. There was, however, clearly an element of catch-up after services activity was hit in the first quarter by the bad weather at the start of the year, and we believe that it exaggerates the current strength of the services sector.

In their July survey, the Bank of England's regional agents reported that "services turnover had continued to grow modestly, reflecting higher demand for professional services, as well as a small increase in distribution activity."

House Prices in July

The Halifax lender is expected to report during the week that house prices fell 0.5% month-on-month in July, following a drop of 0.6% in June. Indeed, this would be a fourth successive decline. This would cause the year-on-year increase in house prices to moderate to 4.6% in the three months to July, from 6.3% in the three months to June, and a peak of 6.9% in the three months to May. The Nationwide lender has already reported that house prices fell by 0.5% month-on-month in July, having been flat in June. Consequently, the year-on-year rise in house prices slowed appreciably to 6.6% in July, from 8.7% in June, and a peak of 10.5% in April on the Nationwide measure.

We suspect that house prices could fall back by 3–5% over the second half of 2010. Housing market activity is currently relatively low, the economic fundamentals are far from ideal for the housing market (notably high unemployment and muted wage growth), a major fiscal squeeze is now starting, and house price/earnings ratios have moved back up overall from their early-2009 lows and are above their long-term averages. On top of this, credit conditions remain tight with mortgages still hard to get for many people. Furthermore, household confidence has been heading down recently and already deepening concerns over the strength and sustainability of the recovery may be intensified by the extra austerity measures that were announced in June's emergency budget. There are also concerns that the Bank of England will raise interest rates before the end of the year due to sticky, above-target inflation. The more worried consumers are, the less likely they will want to commit to buying a house.

Meanwhile, more properties have been 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. It may well be that the new government's decision to abolish Home Information Packs is now contributing to the rise in houses coming on to the market.

On the positive side, some support for house activity and prices will come from the current stamp duty holiday for first-time buyers on all properties costing up to £250,000. And interest rates are likely to stay low for an extended period to offset the fiscal tightening.

Furthermore, it is hard at this stage to be optimistic about house prices in 2011 as the fiscal squeeze will increasingly kick in, which will hit people's pockets and lead to serious job losses in the public sector. Consequently, a further drop of 5–10% in house prices looks highly possible in 2011. Therefore, we believe that house prices could be around 10–12% lower by end-2011 compared with their mid-2010 levels.