Summary

Despite current elevated and rising consumer price inflation, there seems little doubt that the Bank of England's Monetary Policy Committee (MPC) will keep interest rates down at 0.50% at the conclusion of its June meeting on Thursday, given the current softness of the economy, serious concerns about the consumer, and fiscal tightening increasingly kicking in from April.

Indeed, we expect the Bank of England to hold fire on interest rates until at least November, and we believe there is an increasing likelihood the MPC will not act until 2012. We suspect that most MPC members will maintain the view for several more months that higher interest rates are an extra handicap that the fragile economy can do without for the time being.

Furthermore, whenever interest rates do start to rise, the probability is that they will move up relatively gradually and stay very low compared with past norms. We see interest rates only rising to 2.00% by the end of 2012. Monetary policy will need to stay loose for an extended period to offset the impact of the major, sustained fiscal squeeze. In addition, we do believe that inflation will fall markedly later on in 2011 and 2012 as relatively modest, below-trend growth and elevated unemployment limit underlying inflationary pressures. In particular, ongoing substantial pressures on consumers are likely to limit both growth and inflation.

The Bank of England's MPC goes into its June meeting, having lost its arch-hawk Andrew sentence, who left the MPC after its May meeting. This could significantly change the dynamics within the MPC. It remains to be seen how Sentance's replacement, Ben Broadbent, will vote in his first MPC meeting, but his confirmation appearance before Parliament's Treasury Committee suggested that he is nothing like the hawk that Sentance is. In fact, Broadbent stated that "on the broad thrust of policy, I think I would have followed pretty much what the Bank has done".

So the MPC has lost its arch hawk, and while there are still members (Spencer Dale and Ben Broadbent) in favor of higher interest rates, nobody for now at least seems to want to run with the monetary policy tightening baton with the gusto that Sentance did.

Latest Developments

Reflecting the hugely difficult position that the Bank of England is in as it faces muted growth and elevated inflation, some MPC members have recently indicated that their interest-rate decisions are currently finely balanced and could well change if they perceive the balance between growth and inflation risks to change. This includes both Spencer Dale and Martin Weale who currently both favor an immediate 25-basis-point interest-rate hike from 0.50% to 0.75% and Andrew Tucker who currently favors interest rates being kept at 0.50%.

Nevertheless, two MPC members—Paul Fisher and arch-dove Adam Posen—have made it very clear recently that they still favor interest rates being kept at 0.50% for some time to come due to the weakness of the economy, and in particular the pressures on the consumer. In fact, Posen continues to call for more quantitative easing to give the economy a boost.

Latest growth and inflation developments seem to have only intensified the problems that the Bank of England currently faces. GDP growth in the first quarter of 2011 was confirmed at a highly disappointing 0.5% quarter-on-quarter (q/q), which only reversed the 0.5% contraction suffered in the fourth quarter of 2010. This meant that the economy was only flat over the fourth quarter of 2010 and the first quarter of 2011 combined.

Furthermore, the breakdown of the first-quarter GDP data on the expenditure side revealed some unappetizing developments. There was a worrying slump of 0.6% q/q in consumer spending. Just as worryingly, business investment suffered sharp contraction of 7.1% q/q. This raises serious concerns over the state of domestic demand and the economy's ability to withstand the fiscal tightening that increasingly kicked in from April. Having said that, there was some very welcome news with net trade finally making a very strong positive contribution to growth as exports achieved decent growth and imports fell.

Data and survey evidence so far for the second quarter have been somewhat mixed and do little overall to dilute belief that the economy is struggling to generate sustainable decent momentum. In particular, manufacturing activity seems to be faltering appreciably at the moment while the services sector appears to be seeing only modest expansion. Our weighted composite index for the purchasing managers' services, manufacturing, and construction surveys fell to a 2011 low of 53.5 in May from 54.3 in April and a 13-month high of 57.0 in March. In fact, with the exception of December's weather-related hit, our composite index was at its lowest level since October 2010, although it remained clearly above the 50.0 level that indicates only flat activity. Admittedly, retail sales were buoyant in April as they were lifted by the royal wedding, later Easter, and very good weather. Consumer confidence spiked in May, but it is evident that consumers remain under serious pressure as their purchasing power is squeezed. Consumer confidence is still very weak compared with long-term norms.

Meanwhile, the bad news on the inflation front resumed in April after a temporary respite in March. Consumer price inflation spiked to a 30-month high of 4.5% in April after dipping to 4.0% in March from 4.4% in February. This took inflation to more than double the Bank of England's medium-term inflation target of 2.0%. Particularly worryingly, core inflation jumped to a record 3.7% in April from 3.2% in March.

Inflation was pushed up in April by higher utility and petrol prices, and by increased alcohol and tobacco duty. It is also evident that there were different timings in the seasonal rises in some prices due to Easter occurring much later in April in 2011 than in 2010 that held down inflation in March but pushed it up in April. Air transport was the most obvious example. Given the distortions caused by the different timings of Easter, it is probably most meaningful to look at the overall inflation picture for March and April; this shows inflation edging up to 4.5% in April from 4.4% in February.

The minutes of the May MPC meeting show that the hawks once again failed to add to their ranks as none of the other six MPC members joined Sentance, Weale, and Dale in voting for an interest-rate hike. In fact, both Weale and Dale concluded that the current case for a rate rise is "finely balanced," given recent weak economic activity and the uncertainty over the outlook. While Sentance appeared to remain as hawkish as ever, this was his last meeting as an MPC member.

The minutes suggested that while the other six MPC members believe that interest rates will need to rise, they are currently still in no hurry to act, given the recent weakness of the economy, the uncertain outlook, and a lack of evidence that elevated inflation expectations are leading to higher wages. Significantly, the minutes noted that "an increase in Bank Rate in current circumstances could adversely affect consumer confidence, leading to an exaggerated impact on both spending and firms' perception of their desired productive capacity."

And while the data released since the May MPC meeting shows consumer price inflation spiking to a 30-month high of 4.5% in April from 4.0% in March, it should be noted that the Bank of England's latest forecasts (which the MPC had at its May meeting) show inflation reaching 5.0% over the coming months. Latest data and surveys indicate that overall earnings growth remains limited, so there still seems little risk of a serious wage-prices spiral developing. There are some signs in the latest surveys that pay might be picking up modestly in the private sector, but it remains very low compared with long-time norms and is being countered by pay being frozen for many public-sector workers.

Main Economic Indicators

British Retail Consortium Retail Sales Monitor for May

The British Retail Consortium (BRC) retail sales monitor for May (overnight on Monday/Tuesday) will undoubtedly be significantly weaker compared with April, but the crucial question is by how much?

The BRC reported that total sales spiked up 6.9% year-on-year (y/y) in April. This was the best performance for five years and in marked contrast to March when sales had fallen 1.9% y/y, which had been the sharpest decline since the BRC started collecting data in 1995. Meanwhile, sales jumped 5.2% y/y in April on a like-for-like basis (which strips out the effect of additional floor space) after a drop of 3.5% y/y in March. Significantly, though, sales were boosted in April by a pretty powerful combination of factors: the later Easter this year, much improved weather, and the royal wedding. This was evident in the fact that among the strongest-performing sales sectors in April were summer clothing and footwear. In contrast, sales in March had been undermined by the later Easter in 2011.

The general expectation is that retail sales growth will recede markedly in May because of the waning of the special factors that lifted sales in April. The Confederation of British Industry (CBI) has already released its distributive trades survey for May, which actually showed more resilience than expected. Specifically, the balance of retailers in the CBI survey reporting that sales were up y/y retreated to +18% in May, after improving to +21% in April from +15% in March and an eight-month low of +6% in February. Significantly, though, this is well below the average balance of +42% seen in the second half of 2010. It is also notable that the CBI completes its survey much earlier in the month than the BRC, and there may have been a significant "feel good" carryover effect at the start of May from the royal wedding and the good weather.

A resilient BRC survey for May following the spike in retail sales in April would give a significant boost to GDP growth hopes for the second quarter, given the key role of the consumer in the economy (consumer spending accounts for 65% of GDP).

In contrast, a substantially softer BRC survey would indicate that pressurized consumers have quickly put their hands back in their pockets after being encouraged to temporarily loosen their purse strings in April by a particularly favorable combination of factors.

Whatever the outcome of the May BRC survey, it still seems highly likely that consumer spending will be muted over the coming months as household purchasing power remains under severe pressure from high inflation, low wage growth, and tighter fiscal policy. In addition, unemployment is still high and debt levels are elevated. Furthermore, many consumers are likely worried that the Bank of England could start to raise interest rates before long. Even if the Bank of England only edges interest rates up, it will affect consumer psychology as people are bound to see the move as the first in a series of hikes. Meanwhile, the weak housing market has adverse repercussions for consumer spending (healthy housing market activity boosts demand for carpets, fittings, and furnishings as well as major household appliances while rising house prices can have a significant wealth effect).

Trade Deficit in April

The total trade deficit (Wednesday) is expected to have widened to GBP3.2 billion in April from GBP3.0 billion in March and a 12-month low of GBP2.7 billion in February. Even so, this would be markedly below the average monthly deficit of GBP4.1 billion seen in 2010. Within, this, the traded goods deficit is forecasted to have been essentially stable at GBP7.6 billion in April, which would be well below the average GBP8.1-billion monthly deficit in 2010.

The UK's net trade position finally saw major improvement in the first quarter of 2011. The overall trade deficit narrowed to GBP9.3 billion from GBP14.7 billion in the fourth quarter of 2010 while net trade contributed 1.7 percentage points to first-quarter 2011 GDP growth of 0.5% q/q as exports saw decent growth and imports fell. In contrast, net trade had reduced overall GDP growth of 1.3% in 2010 by 0.9 percentage point.

The first-quarter performance raised hopes that decent global growth and a competitive pound are finally helping the economy to achieve some much-needed rebalancing. Nevertheless, it seems unlikely that the economy can sustain such an improved net trade performance, although we do expect it to remain positive overall in 2011.

Surveys from the CBI and the manufacturing purchasing managers showed generally buoyant foreign demand for UK goods in the early months of 2011. Nevertheless, there have been signs in the latest surveys that foreign demand for UK manufactured goods has recently lost momentum. There is a serious risk that global growth could be hit over the coming months by persistent high oil prices while UK exports are also at risk from any sustained problems in key Eurozone markets resulting from recurrent sovereign debt problems.

At the same time, though, we suspect that UK import volumes will be limited by moderate UK domestic demand.

Manufacturing Output and Industrial Production in April

We expect manufacturing output (Friday) to have expanded just 0.1% month-on-month (m/m) in April after a rise of 0.2% in March. This would cause manufacturing output to be up 3.6% y/y in April. Overall industrial production is expected to have risen 0.2% m/m in April, after increasing 0.3% in March, which would leave it up 1.6% y/y.

While manufacturing output was likely held back in April by the extra day's public holiday relating to the royal wedding, there are currently increasing signs that the sector is now faltering appreciably after seeing robust expansion over the first quarter of 2011 and through 2010. May survey evidence from the manufacturing purchasing managers was notably weaker indicating that overall activity was at a 20-month low with new orders contracting modestly for the first time since June 2009. The CBI's industrial trends survey for May was healthier than the purchasing managers' survey and actually showed a pickup in orders after a relapse in April. Even so, it still showed production expectations slipping to a four-month low.

Manufacturers now appear to be finding life more challenging as stock rebuilding wanes and tighter fiscal policy weighs down on domestic demand. There are also signs that global demand is slowing as export orders fell markedly in May. Meanwhile, high oil prices and other elevated input costs have been causing problems for manufacturers by substantially squeezing their margins and putting pressure on them to raise prices and risk losing business. In addition, events in Japan are causing problems for some manufacturing sectors through causing supply-chain disruptions. The Society of Motor Manufacturers and Traders reported that UK car output fell 12.2% in April as production of vehicles and engines was hit by shortages in parts coming from Japan.

Producer Prices in May

Producer price data (Friday) are forecasted to show that output prices rose 0.3% m/m in May, which would be down from increases of 0.8% in April and 1.1% in March. This would see the annual rate of increase remain at 5.3% in May after it eased to this level in April from a 29-month high of 5.6% in March. Core output prices are forecasted to have risen 0.4% m/m in May after climbing 0.6% in April, which would see the y/y increase stable at 3.4%.

Meanwhile, producer input prices are likely to have moderated in May, primarily due to a moderation in oil and commodity prices from recent peak levels. The consensus forecast is for producer input prices to have fallen 1.3% m/m in May, thereby causing the y/y increase to have moderated to a still very nasty 16.0% from 17.6% in April.

Signs that manufacturing activity have moderated recently from extended healthy levels seen in the first quarter of 2011 and through 2010 may well be starting to cause manufacturers to be more circumspect in raising their prices. A recent slight retreat in input prices is easing pressure on manufacturers to raise their prices to protect their margins, although input prices are still elevated. It is notable that both the CBI and the manufacturing purchasing managers reported an easing in output prices in their May surveys. The CBI survey showed that the balance of manufacturers expecting to raise their domestic prices over the next three months retreated appreciably to a five-month low of +24% in May from a 12-year high of +36% in April. In addition, the manufacturing purchasing managers' survey showed the rise in output prices easing to a five-month low in May and input prices increasing at the slowest rate for seven months.

Halifax House Price Index for May

The Halifax lender is expected to report during the week that house prices edged up 0.2% m/m in May, following a drop of 1.4% in April. This would cause prices to be down 4.1% y/y in the three months to May (the Halifax prefers to highlight the three-month y/y house price rate to smooth erratic movements).

We suspect that modest falls in house prices are more probable than not over the coming months as tighter fiscal policy and the possibility of gradually rising interest rates before the end of 2011 maintain pressure on the housing market. On top of that, high unemployment, negative real income growth, elevated debt levels, and still-significant difficulties in getting a mortgage (particularly for first time buyers) do not bode well for house prices. Furthermore, low consumer confidence will make many people reluctant to risk buying a house.

Meanwhile, housing market activity remains at a very weak level that historically has been associated with falling house prices. Latest data from the Bank of England show that mortgage approvals for house purchases fell to a four-month low of 45,166. While mortgage approvals may have been held back to a limited extent in April by the extra bank holiday for the royal wedding and by the later Easter, there is no getting away from the fact that they are very low compared with long-term norms. Mortgage approvals have actually averaged around 90,000 a month since 1993, while a level of 70,000-80,000 has in the past been considered consistent with stable house prices.

Some support to house prices could come if the number of properties coming on to the market is limited over the coming months. The modest help provided to first-time buyers in the March budget is too small to provide major support to the housing market. Meanwhile, affordability measures are mixed. On the favorable side, mortgage payments as a percentage of disposable income are currently very low compared with past norms. Nevertheless, the house price/earnings ratio is above its long-term average.

On balance, we believe that house prices are likely to end up declining some 10% overall by the early months of 2012 from their 2010 highs. This implies that they will fall around 5–8% from current levels depending on which house price measure you take.