It now looks highly likely that an interest rate hike will be delayed until 2012. Mounting growth concerns mean that if the Bank of England does act this year, it is increasingly possible that it will relax monetary policy by reviving Quantitative Easing (QE), which has been on hold since February 2010. However, given still-significant inflation risks, we believe that more QE is unlikely to occur unless the economy truly goes belly-up over the coming months.
Nevertheless, we now expect the Bank of England to refrain from raising interest rates until the second quarter of 2012. We suspect that most members of the Monetary Policy Committee (MPC) will maintain the view for many more months to come that higher interest rates are an extra handicap that the fragile economy can do without.
Furthermore, whenever interest rates do start to rise, the probability is that they will move up only gradually and remain very low compared with past norms. Monetary policy will need to stay loose for an extended period to offset the impact of the major, sustained fiscal squeeze. In addition, we believe that inflation will fall back markedly from late 2011/early 2012.
Consequently, we suspect that interest rates will only rise to 1.50% by the end of 2012 (we have recently trimmed this from a previous forecast of 2.00% by end-2012).
The dynamics and mood within the Bank of England’s Monetary Policy Committee appear to have changed significantly, with a more dovish slant coming to the fore. The minutes of the June MPC meeting reveal that the vote in favour of keeping interest rates at 0.50% widened to 7–2 from 6–3 in each of the previous four months. This was because new member Ben Broadbent supported the "no change" interest rate opinion, which was in marked contrast to his predecessor Andrew Sentence, who had been the MPC's arch hawk and had actually been calling for interest rates to rise by 50 basis points, from 0.50% to 1.00%. Martin Weale and Spencer Dale continued to vote for a 25-basis-point interest rate hike to 0.75% at the June meeting, but they are markedly less hawkish than Sentence was and both acknowledged that "the data on the growth outlook during the month had been weak."
Meanwhile, there was once again an 8–1 vote in favour of keeping the stock of QE unchanged at GBP200 billion, where it has stood since February 2010, with Adam Posen wanting a GBP50-billion increase to GBP250 billion. Interestingly, though, for the first time in many months, the minutes revealed that some other MPC members acknowledged that further QE may be warranted in the future if growth remained weak.
With the minutes of the June meeting appearing appreciably more dovish because of heightened concerns about the economy, it appears increasingly likely that the Bank of England will hold off from raising interest rates until 2012. Furthermore, the possibility of renewed QE seems to be gaining traction.
With respect to economic activity, the minutes observed that "the current weakness of demand growth was likely to persist for longer than previously thought." There is particular concern within the MPC over the weakness of consumer spending, and they are also concerned by evidence of softening global growth. The MPC is also very aware that fiscal tightening increasingly kicked in from April.
Events since the June MPC meeting are likely overall to have added to—rather than eased—growth concerns. For example, consumer confidence suffered a marked relapse in June, while the purchasing managers’ survey points to overall manufacturing activity being at a 21-month low in June with new orders contracting. The Office for National Statistics also revealed this week that output in the dominant services sector plunged 1.2% month-on-month (m/m) in April, which is worrisome, even allowing for the hit to activity caused by the extra public holiday resulting from the royal wedding.
While the MPC acknowledged that consumer price inflation (4.5% in April and May) is likely to reach 5.0% later this year because of utility price increases and stay above the 2.0% medium-term target level for an extended period, the committee drew comfort from the fact that inflation expectations seem relatively stable and wage growth remains muted. This supports the view that inflation will fall back markedly once the pressures from value-added tax changes, higher energy and commodity prices, and sterling's past devaluation wane. Critically, the minutes reveal that "on balance, the Committee judged that the downside risks to the prospects for medium-term inflation had increased over the month."
Forthcoming Main Economic Releases
Construction Activity in June
We forecast the construction purchasing managers index (PMI) out Monday to have edged back to 53.5 in June from 54.0 in May. Given that a reading of 50.0 indicates unchanged expansion, this would point to reasonable but unspectacular activity, and would reinforce the belief that the sector grew in the second quarter after reportedly contracting 3.4% quarter-on-quarter (q/q) in the first quarter.
Major uncertainty persists regarding the true state of the construction sector. The third release of the national accounts data for the first quarter of 2011 trimmed the contraction in construction output again, to 3.4% q/q from 4.0% q/q and the originally reported drop of 4.7% q/q. Nevertheless, this remains a substantially weaker performance than indicated by the survey evidence from the purchasing managers. The construction PMI averaged 55.5 in the first quarter, which was well into expansion territory.
Nevertheless, the construction sector clearly faces a challenging environment, which is likely to limit activity over the coming months.In particular, the coalition government's extended pruning of public spending will clearly limit expenditure on public buildings, schools, hospitals, and infrastructure (even though the government is keen to prioritize some infrastructure projects). Furthermore, housing activity is still very weak compared with long-term norms, house prices are soft, and the outlook for the sector remains worrying, so this could well weigh down significantly on house building.
If the economy continues to struggle for momentum over the coming months, commercial construction activity is likely to be hit with projects put back on hold.
Service Sector Activity in June
The business activity index of the service sector purchasing managers' survey (out Tuesday) is expected to indicate that service sector expansion was essentially stable at a reasonable but hardly buoyant level in June. Specifically, we forecast the business activity index to have edged back to a 2011 low of 53.5 in June from 53.8 in May and a 13-month high of 57.1 in March. A reading above 50.0 indicates expansion, below 50.0 shows contraction.
While business and professional services currently are doing reasonably well, services sector activity is limited by muted consumer spending and the cutbacks in government spending. The purchasing managers reported in May that "the weakness in household consumption remains a drag," while the Bank of England’s regional agents reported in their June survey that the growth rate of nominal spending on consumer services remained sluggish. With regard to business services, the regional agents also reported that “while private sector activity had been growing, a slowing in the public sector was being felt very widely.”
Manufacturing Output and Industrial Production in May
We expect manufacturing output (for which data will be released Thursday) to have appreciably bounced back in May after being held back in April because of the extra public holiday resulting from the royal wedding. It is also possible that some smaller manufacturing companies experienced shutdowns in April because of workers taking extra holiday to tie in with the large number of public holidays pressed into a small period of time.
Specifically, we expect manufacturing output to have risen by 1.1% m/m in May after plunging 1.5% in April, which would lead manufacturing output to register 2.2% year-on-year (y/y). Overall industrial production is also expected to have increased by 1.1% m/m in May after falling by 1.7% in April when it was additionally held back by very good weather limiting utilities’ output. Industrial production would still be down by 0.5% y/y in May.
If industrial production failed to see a decent bounce back in May from April’s sharp drop, it would be a significant blow to GDP growth prospects for the second quarter.
It is evident that manufacturers face more challenges as stock rebuilding wanes and tighter fiscal policy weighs down on domestic demand. In addition, current slower global growth is dampening export orders. Meanwhile, although they have come off their highs, still-elevated input costs are 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 have caused problems for some manufacturing sectors through supply-chain disruptions, although the purchasing managers indicated that these problems eased in June. The Society of Motor Manufacturers and Traders has reported that UK car output was affected in both April and May as production of vehicles and engines was hit by shortages in parts coming from Japan.
Producer Prices in June
Producer price data (out Friday) are forecast to show that output prices rose by just 0.1% m/m in June, which would be down from increases of 0.2% in May. 1.0% in April and 1.1% in March. Still, the y/y increase in output prices would climb to 5.6% in June from 5.3% in May, thereby matching March’s highest level since October 2008. This reflects that producer prices dipped in June 2010. Core output prices are also forecast to have risen by 0.1% m/m in June after an increase of 0.2% in May, which would see the y/y increase ease to 3.1% from 3.4% in May and a 7-month high of 3.6% in April.
Meanwhile, the consensus forecast is for producer input prices to have been flat m/m in June. This would still see input prices up a horrible looking 16.2% y/y.
The recent moderation in manufacturing activity from the extended healthy levels seen through 2010 and in the first quarter of 2011 could cause manufacturers to be more circumspect in raising their prices. A recent easing in input price pressures is reducing pressure on manufacturers to raise their prices to protect their margins although input prices are still elevated. It is notable that the manufacturing purchasing managers reported an easing in output prices in their June survey. Specifically, the survey showed the rise in output prices easing back to a six-month low in June and input prices increasing at the slowest rate since December 2009.
Halifax House Price Index for June
The Halifax lender is expected to report that house prices were flat m/m in June. Prices only edged up 0.1% in May after falling 1.4% in April. This would cause prices to be fall 4.2% y/y in the three months to June (the Halifax index prefers to highlight the three-month y/y house price rate to smooth out erratic movements).
We suspect that modest overall falls in house prices are more likely than not over the second half of 2011 and the first half of 2012.On balance, we believe that house prices are likely to fall by around 8% overall from current levels.
We anticipate that house prices will soften modestly as squeezed purchasing power, tightening fiscal policy, a soft labour market, and worries about the economic outlook weigh down on potential buyers. On top of that, there are still significant difficulties in getting a mortgage (particularly for first-time buyers).
Meanwhile, housing market activity is at a very weak level that historically has been associated with falling house prices. The Bank of England reported that mortgage approvals for house purchases were limited to 45,940 in May, which was essentially only half the average rate seen since 1993.
Not only do economic fundamentals remain difficult overall for the housing market, but the May survey from the RICS (Royal Institution of Chartered Surveyors) indicated that more houses are coming on to the market, thereby diluting the possibility that a shortage of properties could provide significant support to house prices.
The main support for house prices will come from the fact that interest rates are likely to remain very low compared with long-term norms for quite some time. It appears increasingly likely that the Bank of England will refrain from raising interest rates until 2012.