Surprisingly strong GDP growth of 0.8% quarter-on-quarter (q/q) in the third quarter means that it now looks odds-on that the Bank of England's Monetary Policy Committee (MPC) will not only keep interest rates down at 0.50% at the conclusion of its 3–4 November meeting, but will also keep quantitative easing (QE) on hold.

The minutes of the October MPC meeting revealed a three-way split in the vote with Andrew Sentance continuing to vote for a small interest-rate hike from 0.50% to 0.75% while Adam Posen voted for an easing in monetary policy through a £50-billion increase in QE. This was the first time that any MPC member had voted for more QE since the spending came to an end at £200 billion in February. The other seven MPC members voted for both unchanged interest rates and QE.

Up to the release of the third-quarter GDP data, it had seemed increasingly likely the MPC would engage in further QE, possibly as early as the November meeting. These expectations had been fueled by recent signs of faltering growth and confirmation in the government's spending review that it is pressing ahead with major fiscal consolidation. Furthermore, not only had Posen voted for more QE at the October meeting, but the minutes also noted that some of the other members "felt the likelihood that further monetary stimulus would become necessary in order to meet the inflation target in the medium term had increased in recent months."

Also potentially significantly, the MPC will have the Bank of England's latest GDP growth and consumer price inflation forecasts (prepared for the new quarterly inflation report) available at its November meeting and the committee has been more prone to change monetary policy when it has had new forecasts available.

We suspect that the resilience of GDP growth in the third quarter will convince most MPC members that there is no need at this stage to provide further support to the economy, particularly as consumer price inflation remained disappointingly sticky and well above-target at 3.1% in September.

In fact, Andrew Sentance will undoubtedly argue at the November MPC meeting that the third-quarter GDP growth performance supports his case that a small interest-rate hike is warranted.

Nevertheless, we anticipate Sentance will remain on his own in calling for higher interest rates as we believe that the rest of the MPC will remain concerned—despite the resilient GDP performance in the third quarter—that private-sector growth may not be able to compensate fully for the fiscal squeeze and less favorable stock developments, thereby resulting in an extended period of below-trend growth. Given substantial excess capacity, this would risk seeing consumer price inflation substantially undershooting its 2.0% target rate on the two-year policy horizon.

While we doubt that the MPC will vote for any extension to QE at the November meeting, it remains very possible in the early months of 2011 should the economy lose serious momentum as the fiscal tightening increasingly bites. Significantly, Bank of England Governor Mervyn King has recently played down quarterly GDP growth movements and highlighted that total U.K. output is markedly below where it would have been had the economic crisis not occurred. This suggests that he is open to further stimulative measures if growth falters markedly going forward and is no hurry to raise interest rates. King is also highly supportive of the government's fiscal tightening stance, and appears to be prepared to keep monetary policy relaxed to offset this

We still expect interest rates to stay down at the current record-low level of 0.50% until at least late 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 at 0.50% until 2012.

Main Economic Releases

Manufacturing Purchasing Managers' Survey for October

The manufacturing purchasing managers' survey (PMI; out Monday) is expected to show that the sector expanded at a decent rate in October, but nevertheless lost a little more momentum compared with the peak levels seen in the second quarter. Specifically, we forecast the PMI to slip to 53.3 in October, after trending down to an 11-month low of 53.4 in September from 54.3 in August and 58.0 in May (which was the highest level since September 1994). Nevertheless, a reading of 53.3 in October would still be comfortably above the critical 50.0 level that indicates unchanged activity. The Confederation of British Industry (CBI) has already released its industrial trends survey for October. This showed the total order book fell sharply to a six-month low of -28% in October from -17% in September. This was influenced heavily by lower export orders. Nevertheless, companies' near-term production expectations spiked to a 31-month high in October.

Manufacturers benefited earlier this year from healthier demand both at home and overseas, improved competitiveness in both domestic and foreign markets stemming from the weak pound, and a need to rebuild stocks after they were pared during the recession.

The concern is that manufacturers will see softer growth over the coming months as stock rebuilding winds down, tighter fiscal policy increasingly weighs down on domestic demand, and slower global growth hits foreign demand for U.K. products.

Construction Activity in October

The construction PMI (Tuesday) is likely to indicate overall activity is now expanding at a markedly reduced rate, after the national accounts data showed that output in the sector jumped a further 4.0% q/q in the second quarter of the year after surging 9.5% q/q in the second quarter. We expect the PMI to have eased to 53.0 in October, after rebounding to 53.8 in September from a six-month low of 52.1 in August. The index peaked at 58.5 in May. A reading above 50.0 is meant to indicate expanding activity.

The strength of construction output in the second and third quarters was influenced by a number of special factors. There was a strong element of catch-up reflecting that the rise in output came off a very low base as the construction sector suffered deep contraction during the recession, while it was also held down at the start of 2010 by the very bad weather. In addition, the construction sector benefited in the second and third quarters from past government stimulus measures.

These special factors are now waning and there are mounting signs that the construction sector is losing momentum. Although the construction purchasing managers' business activity index improved in September after trending down since May, scratch below the surface and the survey pointed to further moderation in construction activity ahead. In particular, new orders growth retreated to a seven-month low in September, business expectations weakened appreciably to a 21-month low, and employment in the sector contracted for a third month running and at the fastest rate since March.

The construction sector faces a very challenging environment, which is likely to limit activity. 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 (even though the government is keen to prioritize some infrastructure projects). 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. The purchasing managers' survey indicated contraction in house building activity in September for the first time since August 2009

Service Sector Activity in October

The service sector PMI (Wednesday) is forecasted to indicate that activity expanded at a relatively modest rate in October. Specifically, we expect the business activity index to have essentially stabilized at 52.7 in October after picking up to 52.8 in September from a 16-month low of 51.3 in August. A reading above the 50.0 level is meant to indicate expanding activity. Although the business activity index picked up in October, it remained well below the 56–58 levels seen earlier this year. Furthermore, other elements of the September survey did not bode particularly well for future activity. In particular, incoming new business growth diminished further to be at a 15-month low in September and was only modest.

The Bank of England's regional agents reported in their October survey that "services turnover continued to grow modestly." Nonetheless, they noted that the impact of tightening public-sector spending continued to be a concern for many services firms.

Producer Prices in October

Producer price data (Friday) are forecasted to show that output prices rose 0.2% month-on-month (m/m) in October, having risen 0.3% in September. This would cause the annual rate of increase to remain at 4.4%, having previously fallen to this level in September from 4.7% in August and a peak of 5.9% in May. Core output prices are also forecasted to have risen 0.2% m/m in October, which would be down from a disappointingly high increase of 0.4% in September. This would see the year-on-year (y/y) increase moderate to 4.4% in October from 4.6% in both September and August, and a peak of 5.0% in June.

Manufacturers have clearly looked to take advantage of improved manufacturing activity this year to push through price increases to support their margins in the face of elevated costs. It seems likely manufacturers will find it increasingly difficult to raise their prices in the coming months, given appreciable excess capacity and likely slower expansion. Significantly, the Confederation of British Industry's October industrial trends survey revealed that the balance of manufacturers expecting to raise their domestic prices receded markedly to +6% in October from +15% in September.

Meanwhile, the consensus is for producer input prices to have risen 0.8% m/m in October after an increase of 0.7% in September. Nevertheless, this would cause the y/y increase in input costs to moderate to 7.1% in October from 9.5% in September and a peak of 12.8% in April.

Halifax House Price Index for October

The Halifax lender is expected to report during the week that house prices fell 0.3% m/m in October, after plunging 3.6% in September. The sharp drop in house prices reported by the Halifax in September caused major headlines, but it highlighted just how volatile housing market data can be from month to month and survey to survey. It is clear that the 3.6% plunge in September was partly a correction to the surprising rises in house prices reported by the Halifax in August and July, which conflicted with other data and surveys. In fact, overall data from the Halifax and the Nationwide lenders both showed house prices falling 1.0% q/q in the third quarter.

A 0.3% drop in house prices in October would see the y/y increase moderating to just 0.4% in the three months to October, from 2.6% in the three months to September and a peak of 6.9% in the three months to May. House prices would actually be down 2.5% y/y in October itself (the Halifax prefers to highlight the three-month y/y house price rate to smooth out erratic movements). The Nationwide has already reported that house prices fell 0.7% m/m in October, having been flat in September. The y/y rise in house prices slowed to 1.4% in October, from 3.1% in September and a peak of 10.5% in April on the Nationwide lender's measure.

We expect house prices to fall 10% overall during the final months of 2010 and in 2011. High (and likely-to-rise) unemployment, muted wage growth, an increasing fiscal squeeze, low consumer confidence, difficulties in getting a mortgage, a housing supply/demand balance currently firmly in favor 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.