Summary

There is little doubt that the Bank of England will keep interest rates at 0.50% for the 18th successive month at the September meeting of its Monetary Policy Committee (MPC), which concludes Thursday. While Andrew Sentance will probably maintain his stance that a small rise in interest rates is justified, he is highly likely to remain a lone voice within the MPC calling for such a move. We suspect that the other eight MPC members will conclude that the serious headwinds facing what is still overall muted recovery from very deep recession warrant unchanged interest rates. Recent surveys relating to services, manufacturing, and construction activity in August have been markedly weaker. Furthermore, there is evidence that underlying inflationary pressures are abating.

If the MPC does make any adjustments to monetary policy in the near term, it is most likely to be to revive quantitative easing, which has been on hold since the last of the current stock of £200 billion was spent in February. The Bank of England is clearly concerned by the threat to economic activity stemming from persistently tight credit conditions, and latest news on this front remains worrying.

Analysis

The Bank of England continues to tread a difficult policy path as it faces still-muted overall economic recovery following deep recession, significant growth headwinds, and persistent above-target inflation. This is reflected in the fact that at its August meeting the MPC discussed the case for both a modest easing and a modest tightening of monetary policy (as it had also done at the July meeting).

Although U.K. GDP spiked 1.2% quarter-on-quarter in the second quarter, the Bank of England is very well aware that this substantially exaggerates the strength of the economy and that it is still at risk from serious headwinds. These notably include the extended substantial fiscal squeeze that will increasingly kick in over the coming months and persistently tight credit conditions. In addition, there is currently serious concern over global growth prospects (particularly over the United States), while sovereign debt problems in the Eurozone could easily resurface. Meanwhile, U.K. consumers face high unemployment, muted wage growth, and elevated debt levels in addition to the looming fiscal squeeze.

Although consumer spending appears to be holding up pretty well in the third quarter and latest export data have finally shown welcome and somewhat belated improvement, other data and survey evidence have fueled suspicion that the United Kingdom is headed for softer activity over the coming months. In particular, survey evidence from the purchasing managers reveals significantly reduced service sector, manufacturing, and construction expansion in August. Our weighted composite purchasing managers' index for those sectors fell to a 14-month low of 51.9 in August from 53.8 in July and 56.0 in May, thereby being only modestly above the 50.0 level that indicates flat activity.

Meanwhile, although it has been persistently above the Bank of England's 2.0% target level, consumer price inflation nevertheless moderated to 3.1% in July from a peak of 3.7% in April. Furthermore, core inflation (which excludes energy, food, alcohol. and tobacco prices) ebbed to an eight-month low of 2.6% in July from 3.1% in June. It is also worth noting that consumer price inflation, excluding indirect taxes, was just 1.4% in July, which was down from 2.0% in April and 3.0% in November 2009.

Furthermore, according to the minutes of the August MPC meeting, the central view of the MPC remains that "the weight of evidence continued to suggest that the margin of spare capacity (in the economy) 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." These temporary factors include sterling's past depreciation, value-added tax (VAT) changes, and energy and commodity price movements.

Admittedly, the MPC does have significant inflationary concerns. In particular, there is concern within the committee that with consumer price inflation now likely to remain above its 2.0% target through much of 2011 due to next January's VAT hike (from 17.5% to 20.0%), inflation expectations could become entrenched at a higher level, thereby making it harder to bring consumer price inflation down to 2.0%. It does seem unlikely that higher inflation expectations would fuel wage growth, because of the slack in the labor market.

Our view is that the Bank of England is most likely to keep interest rates at 0.50% during the rest of 2010 and through the first half of 2011. Furthermore, it seems odds-on that interest rates will 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 major, sustained fiscal squeeze. We currently forecast the first interest-rate hike to 0.75% to come in the third quarter of 2011 and see interest rates still only at 1.25% at the end of next year. Meanwhile, there is clearly a very real possibility that the Bank of England could revive quantitative easing, should the economy falter appreciably over the coming months and credit conditions remain tight.

Main Economic Releases

British Retail Consortium Retail Sales Monitor for August

The British Retail Consortium (BRC) retail sales monitor for August (out overnight on Monday/Tuesday) is expected to show relatively healthy sales, supported by good weather early in the month, people looking to enjoy their summer holidays, and decent discounting on the high street. The Confederation of British Industry (CBI) has already released its distributive trades survey for August, which showed that the balance of retailers reporting that sales were up year-on-year climbed to a 40-month high of +35% from +33% in July and -5% in June. We expect the BRC to report that total retail sales rose 3.1% year-on-year (y/y) in August, while sales are expected to have increased 1.0% on a like-for-like basis (which strips out the effect of additional floor space). The BRC previously reported that total retail sales rose 2.6% y/y in July while they were up 0.5% y/y on a like-for-like basis. Hard data from the Office for National Statistics show that retail sales volumes rose 1.1% month-on-month (m/m) in July.

If the BRC August survey is healthy, it will add to the evidence that consumer spending has been pretty resilient in the third quarter after growing by a healthy 0.7% quarter-on-quarter (q/q) in the second quarter. This would be particularly welcome news, given the importance of consumer activity to the economy (it accounts for 62% of GDP). It would also ease some of the concerns over faltering economic activity that have been stoked by the recent surveys from the purchasing managers showing markedly reduced expansion in services, manufacturing, and construction activity in August.

Conversely, a weak BRC survey would further stoke fears that growth is faltering markedly.

In fact, the suspicion is that, going forward, consumers will find life hard and will be constrained in their spending. The substantial fiscal squeeze will increasingly hit public-sector jobs and consumers' pockets, while households already face high unemployment, muted earnings growth, and elevated debt levels.

Longer term, retail sales will be hit by VAT rising from 17.5% to 20.0% in January 2011, although this could bring forward some spending later this year as consumers look to make purchases of more expensive items ahead of the increase.

Manufacturing Output in July

We expect manufacturing output (Wednesday) to have expanded 0.3% m/m in July as it did in June. This would push y/y growth to 4.9%. Overall industrial production is expected to have expanded 0.4% m/m in July, after falling 0.5% in June when it was dragged down by a plunge in mining and quarrying output due to maintenance work in the North Sea being carried out during the month instead of August as usual.

While manufacturing output should have seen decent expansion in July, latest survey evidence from the purchasing managers suggests that the sector could be starting to lose momentum. Manufacturers benefited in 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 lean stock levels. Nevertheless, the suspicion is that manufacturers will see softer growth over the coming months as inventory adjustment comes to an end, tighter fiscal policy increasingly bites, and global growth slows.

Producer Prices in August

Producer price data (Friday) are likely to show that output prices rose just 0.1% m/m in August, as they did in July. This would cause the annual rate of increase to ease to 4.8% in August, from 5.0% in July and a peak of 5.9% in May. Core output prices are also forecasted to have risen a modest 0.1% m/m in August after a 0.2% increase in July. This would see the y/y increase slow to 4.6% in August, from 4.7% in July and 5.0% in June.

Manufacturers clearly took advantage of improved manufacturing activity to push through price increases in the early months of this year to support their margins in the face of rising costs. It seems likely that manufacturers will find it increasingly difficult to raise their prices, given significant excess capacity and likely slower expansion. Furthermore, pressure on manufacturers to raise their prices has eased recently as input prices have receded after spiking earlier this year. The consensus is for producer input prices to have risen 0.1% m/m in August after dipping 1.0% in July. This would cause the y/y increase in input costs to moderate to 8.9% from 10.8%.

Trade Deficit in July

The total trade deficit (Thursday) is expected to have edged down further to £3.2 billion in July, after narrowing to £3.3 billion in June from a 22-month high of £3.8 billion in May. Within this, the visible trade deficit is forecasted to have shrunk to £7.3 billion in July from £7.4 billion in June and £8.0 billion in May.

The United Kingdom's export performance so far in 2010 has been largely lackluster and disappointing, given the past sharp depreciation of the pound and improved global growth and trade. Exports spiked 2.6% m/m in June, thereby raising hopes that U.K. exporters are finally starting to benefit from sterling's weakness and that this will help prop up growth over the coming months. The concern is that exports will be hit over the coming months by slowing global growth.

Halifax House Price Index for August

The Halifax lender is expected to report during the week that house prices fell 0.5% m/m in August. Although prices rose 0.6% m/m in July, this followed declines in each of the previous three months. The y/y increase in house prices is seen moderating to 4.5% in the three months to August from 4.9% in the three months to July and a peak of 6.9% in the three months to May. Annual house price growth is also seen easing to 3.4% in August itself from 4.8% in July and a peak of 8.7% in April. The Nationwide lender has already reported that house prices fell 0.9% m/m in August after dropping 0.5% in July. The y/y rise in house prices slowed sharply to just 3.9% in August from 6.6% in July and a peak of 10.5% in April on the Nationwide measure.

We expect house prices to fall up to 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 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 obtain for many people.

Meanwhile, more properties have been coming onto the market, thereby moving the supply/demand balance more in favor of buyers. This is particularly relevant as a shortage of properties was a key factor in the recovery in house prices from their early-2009 lows.

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. Interest rates are likely to stay low for an extended period to offset the fiscal tightening.

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 around 5% in house prices looks highly possible in 2011, and the drop could well be steeper still. Much will depend on mortgage availability and the amount of houses coming onto the market, as well as how well the economy holds up. Therefore, we suspect that house prices will be at least 10% lower by end-2011 compared with their mid-2010 levels.