BANK OF ENGLAND OCTOBER POLICY MEETING
The Bank of England seems poised to keep interest rates down at 0.50% for the 20th successive month at the conclusion of the October meeting of its Monetary Policy Committee on Thursday. While consumer price inflation at 3.1% in August remains sticky and significantly above the Bank of England's 2.0% target level, it is evident that there is serious concern within the MPC that still limited and fragile recovery from deep recession could be derailed by serious headwinds. These headwinds most notably include major fiscal tightening increasingly kicking in, persistently tight credit conditions, and slowing global growth.
Indeed, if the MPC does act in the near term, it will highly likely to be to revive Quantitative Easing, which has been on hold since February. This is now looking a very real possibility should the economy lose further momentum and credit conditions remain tight.
In fact, one MPC member, Adam Posen, has indicated that he may well vote for a resumption of Quantitative Easing at the October meeting, although we still expect the MPC to hold fire for the time being at least. With Andrew Sentance conversely indicating that he still favours an immediate small interest rate hike to 0.75%, a three-way split among the MPC looks on the cards at the October meeting.
We expect the Bank of England to keep interest rates down at 0.50% during the rest of 2010 and deep into 2011. Specifically, we forecast the first interest rate hike to come in the fourth quarter of 2011 and see interest rates still only at 0.75% at the end of next year. Furthermore, we would not rule out interest rates staying down at 0.50% until 2012. Whenever interest rates do finally start to rise, they are likely to increase only gradually and remain very low compared to past norms, as monetary policy will need to remain loose for an extended period to offset the impact of the major, sustained fiscal squeeze.
Background to Meeting
The minutes of the September MPC meeting came across as distinctly more dovish, heightening belief that if the Bank of England acts at all in the near term, it will be aimed at stimulating the economy. While Andrew Sentance retained his view that a small rise in interest rates is warranted, he remained a lone voice. The minutes indicated that some MPC members are increasingly leaning towards the view that further action is needed to support growth. Specifically, the minutes reported that "For some of these members, the probability that further action would become necessary to stimulate the economy and keep inflation on track to hit the target in the medium term had increased."
The minutes noted that latest evidence pointed to a slowdown in growth in the second half, and revealed that some MPC members are becoming increasingly worried over the headwinds to recovery that notably include tightening fiscal policy, slowing global growth, and tight credit conditions. In addition, stock developments are seen becoming less supportive to growth. There was growing concern within the MPC that demand in the private sector will not be able to compensate for the sharp reining in of public sector activity.
There continued to be concern within the MPC that persistent above target consumer price inflation could lead to higher inflation expectations becoming entrenched among workers and businesses. This could then increasingly affect wage demands and influence companies' pricing policies. The MPC considered overall that most of the evidence pointed to relatively stable inflation expectations, while pay remains muted. The MPC also retained the overall view that there is enough spare capacity in the economy to bring consumer price inflation down to its 2.0% target level in the medium term once the upward impact of sterling's past depreciation, Value-added tax changes and energy and commodity price movement had waned.
Indeed, there was considered to be an increased risk that markedly reduced growth going forward could result in the margin of spare capacity within the economy rising, thereby leading consumer price inflation to fall "materially" below its 2.0% target level over the medium term.
Latest comments by Andrew Sentance indicate that he will continue to vote for a 25-basis-point interest rate hike to 0.75% at the October meeting. But there seems little likelihood of any other MPC member joining him.
In fact, developments since the September MPC meeting are likely to have at least maintained the committee's concerns over faltering growth and may well have deepened them. Indeed, comments by Adam Posen in late September indicated that he could well vote at the meeting for Quantitative Easing to be resumed to try and ensure that the UK does not suffer prolonged economic weakness.
Although GDP growth in the second quarter was confirmed at a heady 1.2% quarter-on-quarter, latest data and survey evidence seem increasingly to be pointing to a marked slowdown in activity. In particular, the Office for National Statistics has reported that services output contracted by 0.2% quarter-on-quarter in July, manufacturing surveys point to slowing expansion and consumer confidence fell anew in September after rising for the first time in six months in August. On a more positive note, a CBI survey pointed to robust retail sales in September, but latest hard data nevertheless how that retail sales fell by 0.5% in August
KEY ECONOMIC RELEASES
Construction Activity in September
The construction purchasing managers index (PMI - out on Monday) is likely to show that overall activity is now expanding at a much reduced rate after the spike up in activity in the second quarter. We expect the PMI to have eased back further to 51.6 in September, having dropped sharply to a six-month low of 52.1 in August from 54.1 in July and a peak of 58.5 in May. A reading above 50.0 is meant to indicate expanding activity.
Although the national accounts data show that construction output spiked up by 9.5% quarter-on-quarter in the second quarter, this was inflated substantially by special factors (including activity being held down in the first quarter by the very bad weather at the start of the year and a boost from past government stimulus measures).
Indeed, while the construction sector still appears to be expanding after suffering extended, deep recession in 2008/9, it faces a very challenging environment. This will likely cause the sector's recovery to be gradual overall and bumpy. In particular, construction activity will be hit appreciably by the coalition government's extended pruning of public spending as this is clearly going to hit expenditure on public buildings, schools, hospitals and infrastructure. Furthermore, housing market activity has been muted in recent months, prices are softening and the outlook for the sector is currently looking increasingly worrisome, so this could well weigh down on house building. Indeed, the purchasing managers' house building index fell sharply to a 10-month low in August
Service Sector Activity in September
The service sector purchasing managers' index (out on Tuesday) is forecast to indicate that activity expanded at a modest rate in September. Specifically, we expect the business activity index to have stabilized at 51.3, after falling sharply to this level in August from 54.5 in July. This is the lowest level since June 2009, although it is at least still above the 50.0 level, which is meant to indicate unchanged activity. There are worrying signs that the services sector has lost significant momentum recently, and it was not just the headline business activity that was markedly softer in the August purchasing managers' survey but also several of the more forward-looking components, most notably incoming new business.
Furthermore, the Office for National Statistics has reported that service sector output fell 0.2% month-on-month in July, primarily due to drops in the output of the business, service, and finance sector and in the government and other services sector. This may be a sign that fiscal tightening is already starting to have some impact. On a slightly more positive note though, the Bank of England's regional agents reported in their September survey that "services turnover continued to rise modestly."
Manufacturing Output in August
We expect manufacturing output (out on Thursday) to have expanded 0.2% month-on-month in August, which would be down from an increase of 0.3% in each of the previous three months. Nevertheless, the year-on-year increase would spike up to 5.8% in August from 4.9% in July as manufacturing output dipped in August 2009. Overall industrial production is expected to have expanded by 0.2% month-on-month in August, after rising by 0.3% in July. This would see year-on-year growth in industrial production jump to 4.1% in September from 1.9% in August. This reflects the fact that industrial production was held down in August 2009 by a plunge in mining and quarrying output due to maintenance work in the North Sea. This took place in June this year.
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. Overall, the evidence suggests that manufacturing growth has slowed during the third quarter, although it is still decent. Going forward, the concern is that manufacturing activity will be increasingly pressurized by tighter fiscal policy increasingly hitting domestic demand, global growth slowing and stock rebuilding winding down.
Producer Prices in September
Producer price data (out Friday) are likely to show that output prices rose by just 0.1% month-on-month in September, having been flat in August. This would cause the annual rate of increase to ease to 4.3% in September from 4.7% in August and a peak of 5.9% in May. Core output prices are also forecast to have risen by a modest 0.1% month-on-month in September, which would match the August outturn. This would see the year-on-year increase moderate to 4.2% in September from 4.6% in August 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 risen at a reduced rate after spiking up earlier this year. The consensus is for producer input pricesto have risen by a relatively modest 0.3% month-on-month in September after dipping over the previous three months. Nevertheless, this would cause the year-on-year increase in input costs to rise back up to 8.6% in September after trending down to 8.1% in August and a peak of 12.8% in April.
Halifax House Price Index for September
The Halifax lender is expected to report during the week that house prices fell 0.2% month-on-month in September after rising 0.2% in August. The year-on-year increase in house prices is seen moderating to 3.9% in the three months to September from 4.6% in the three months to August and a peak of 6.9% in the three months to May. Annual house price growth is also seen easing to 2.5% in September itself from 4.3% in August and a peak of 8.7% in April. The Nationwide lender has already reported that house prices edged up 0.1% month-on-month in September after dropping 0.8% in August. The year-on-year rise in house prices slowed to 3.1% in September from 3.9% in August and a peak of 10.5% in April on the Nationwide measure.
We expect house prices to fall 10% overall during the final months of 2010 and in 2011. High unemployment, muted wage growth, an increasing fiscal squeeze, low consumer confidence, difficulties in getting a mortgage, a housing supply/demand balance currently firmly in favour of buyers and a house price/earnings ratio above long-term norms are a poor combination of factors for house prices. Low interest rates and the current stamp duty holiday for first-time buyers on all properties costing up to £250,000 only partially offset these adverse factors.
4 Oct - Construction Purchasing Managers Index, September: 51.6
5 Oct - Service Sector Purchasing Managers Index, September: 51.3
7 Oct - Industrial Production, August (Month-on-Month): +0.2%
7 Oct - Industrial Production, August (Year-on-Year): +4.1%
7 Oct - Manufacturing Output, August (Month-on-Month): +0.2%
7 Oct - Manufacturing Output, August (Year-on-Year): +5.8%
8 Oct - Producer Price Output Inflation, September (Month-on-Month): +0.1%
8 Oct - Producer Price Output Inflation, September (Year-on-Year): +4.3%
8 Oct - Core Producer Price Output Inflation (ex Food, Tobacco etc.) September (Month-on-Month): +0.1%
8 Oct - Core Producer Price Output Inflation (ex Food, Tobacco etc.) September (Month-on-Month): +4.2%
During Week - Halifax House Prices, September (Month-on-Month): -0.2%
During Week - Halifax House Prices, September (3-Month/Year-on-Year): +3.9%