Summary
The current softness of the economy and serious concerns over the outlook mean that not only are unchanged interest rates of 0.50% a foregone conclusion at the conclusion of the August meeting of the Bank of England’s Monetary Policy Committee (MPC) meeting on Thursday, but it is looking evermore probable that the bank will not tighten monetary policy before the middle of 2012.
If the Bank of England does act anytime soon, it seems more likely to be to relax monetary policy through reviving quantitative easing, which has been on hold since February 2010. The indications are that the majority of MPC members are currently wary about going down the quantitative easing path again, given still-significant inflation risks, so we believe that more quantitative easing is unlikely to occur unless the economy suffers extended major weakness.
We currently expect the Bank of England to hold off from raising interest rates until mid-2012, and would not be surprised if it held off from acting until even later than this. We suspect that most MPC members will maintain the view for some considerable time to come that higher interest rates are an extra handicap that the fragile economy can well 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 do believe inflation will fall markedly from late 2011/early 2012. Consequently, we suspect interest rates will only rise to 1.50% by the end of 2012.
Background to August MPC Meeting
The voting patterns within the MPC were unchanged at its July meeting with a solid 7:2 majority in favor of keeping interest rates at 0.50% and only Adam Posen currently favoring more quantitative easing.
Significantly though, the underlying tone of the minutes of the July MPC meeting came across as distinctly more dovish, thereby indicating that any raising of interest rates is disappearing further into the future. Critically, the minutes note that “it was likely that the current weakness in activity would persist for longer than previously thought” and for most members, “recent developments had reduced the likelihood that a tightening in policy would be warranted in the near term.”
Admittedly, Martin Weale and Spencer Dale maintained their view that there was still a strong argument for removing some of the monetary stimulus (and Weale reiterated this view in late July), but there is little sign that any other MPC member feels inclined to join them any time soon.
On the growth front, the MPC considered that underlying growth was modest in the second quarter, stripping out the impact of the supply disruptions from Japan and the extra public holiday due to the royal wedding. It was worried by signs that underlying manufacturing and services growth might soften in the third quarter. In addition, the members are concerned by signs that consumer spending will remain weak in the near term.
Developments since the July MPC meeting are unlikely to have eased the committee’s concerns over the growth outlook. A preliminary estimate put GDP growth at just 0.2% quarter-on-quarter (q/q) in the second quarter, following overall flat economic activity in the first quarter of 2011 and the fourth quarter of 2010 combined. As a result, GDP was up just 0.7% year-on-year (y/y) in the second quarter. Admittedly, the Office for National Statistics indicated that special factors could have knocked off up to 0.5 percentage point of second-quarter growth—including the extra public holiday resulting from the royal wedding, manufacturing supply-chain disruptions resulting from the Japanese tsunami earlier this year, maintenance work in the North Sea hitting oil and gas extraction, and warm weather in April and May reducing utilities output.
Nevertheless, there are serious uncertainties over just how much these factors held back growth in the second quarter and the fact is that the UK economy has barely grown since the end of the third quarter of 2010. Furthermore, latest data and survey evidence is undeniably soft overall.
Survey evidence for July from the Confederation of British Industry (CBI) points to weak retail sales in July while consumer confidence fell markedly in July and was extremely low compared with long-term norms. Another CBI survey shows a marked softening in manufacturing orders and growing concern within the sector over the outlook.
The MPC does still have serious inflation concerns. Despite being informed that consumer price inflation had dipped to 4.2% in June from 4.5% in May, the MPC considered that “the peak in inflation was likely to be a little higher and come sooner than… previously expected.” In fact, it is now seen going over 5% later this year due to the size of utility price hikes that will kick in from October.
Most MPC members are drawing comfort from the little clear evidence that elevated inflation has begun to feed through into wages, and they take the view that the significant degree of labor market slack will continue to hold down earnings growth for some time. This suggests they see little danger of a damaging wages-prices spiral developing. This supports the view that inflation would fall markedly once the pressures from value-added tax (VAT) changes, higher energy and commodity prices, and sterling's past devaluation waned.
Major Economic Releases
Manufacturing Purchasing Managers' Survey for July
The manufacturing purchasing managers' index (PMI; out Monday) is expected to show that the sector saw activity slowing further in July, thereby extending its loss of momentum from the healthy levels seen in early 2011 and through 2010. Specifically, we forecast the PMI to have fallen to a 22-month low of 50.8 in July from 51.3 in June, 56.2 in March, and a record (1992) high of 61.9 in January. This would point to only marginal overall expansion in the sector, given that a reading of 50.0 indicates unchanged activity.
The CBI has already released its industrial trends survey for July, which showed softer order books, reduced foreign demand, rising stock levels, and production expectations for the next three months falling to an eight-month low. Some good news for the Bank of England in the CBI survey was a marked retreat in manufacturers’ pricing expectations and this is likely to be replicated in the purchasing managers’ survey.
It is evident manufacturers are now finding life more challenging as domestic demand is held back by serious headwinds, notably including tightening fiscal policy and a major squeeze on consumers, while recent slower global growth is dampening export orders. Meanwhile, although they have come off their highs, elevated input costs remain a problem for manufacturers.
On a positive note, there are reports that supply-chain disruptions for UK manufacturers resulting from the Japanese disaster earlier this year are now easing.
Construction Purchasing Managers' Survey for July
We forecast the construction PMI (Tuesday) to have edged back to a seven-month low of 53.1 in July from 54.0 in June. Given that a reading of 50.0 indicates unchanged expansion, this would point to reasonable but unspectacular activity.
Preliminary national accounts data indicate that the construction sector returned to modest growth in the second quarter after contracting in both the first quarter and the fourth quarter of 2010 (when it was hit hard by December’s bad weather). Specifically, construction output expanded 0.5% q/q in the second quarter, but this was a tepid rebound following contraction of 3.4% q/q in the first quarter and 2.1% q/q in the fourth quarter of 2010. Construction output was down 1.4% y/y in the second quarter.
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 on hold again.
Service Sector Purchasing Managers' Survey for July
The business activity index of the service sector purchasing managers' survey (Wednesday) is expected to indicate that service sector activity slowed modestly in July but nevertheless saw clear expansion. Specifically, we forecast the business activity index to have edged down to a 2011 low of 53.4 in July from 53.9 in June 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 seem to be doing reasonably well, services sector activity is being limited by muted consumer spending and the cutbacks in government spending. The Bank of England’s regional agents reported in their July survey that “steady growth in output in the business services sector was continuing” but that “growth of consumer services turnover remained weak. And there had been a fall in discretionary spending on services.”
Producer Prices in July
Producer price data (Friday) are forecast to show that output prices rose just 0.1% month-on-month (m/m) in July, as they did in June. This is down markedly from the increases seen in the first four months of the year. Even so, this would still see the y/y increase in output prices edge up to a 33-month high of 5.8% in July from 5.7% in June, reflecting producer prices were flat m/m in July 2010. Core output prices are also forecast to have risen 0.1% m/m in July after an increase of 0.2% in June, which would see the y/y increase ease to a four-month low of 3.1% in July from 3.2% in June and a seven-month high of 3.6% in April.
Meanwhile, the consensus forecast is for producer input prices to have risen by 0.7% m/m and 18.8% y/y in July.
There are increasing indications that the recent marked slowdown in manufacturing activity is causing manufacturers to become more circumspect in raising their prices. An easing in oil and commodity prices from their peak levels earlier this year has modestly eased pressure on manufacturers to raise their prices to protect their margins, although input prices are still elevated. It is notable that the CBI’s July industrial trends survey showed the balance of manufacturers expecting to raise their domestic prices over the next three months falling sharply to a 19-month low of +4% in July from +27% in June and a 12-year high of +36% in April.
Halifax House Price Index for July
The Halifax lender is expected to report during the week that house prices were flat m/m in July after spiking 1.2% in June. Despite the spike in prices in June, the Halifax data still showed house prices falling 0.5% q/q in the second quarter. Flat house prices in July would see house prices down 2.8% y/y in the three months to July (the Halifax prefers to highlight the three-month y/y house price rate to smooth erratic movements).
We expect house prices to fall around 5% from current levels by mid-2012. We anticipate that house prices will trend down modestly as squeezed purchasing power, tightening fiscal policy, a soft labor market, and worries over 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).
Not only do economic fundamentals remain difficult overall for the housing market, but there is currently little evidence that a shortage of properties could provide significant support to house prices. The National Association of Estate Agents has reported the stock of unsold properties on estate agents books spiked to a two-year high in June. Meanwhile, Rightmove has reported that 70% of properties that were newly marketed in the first half of 2011 were still for sale in July.
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 some considerable time to come. Indeed, it is looking evermore likely the Bank of England will hold off from raising interest rates until well into 2012, or even beyond.
