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Economics Weekly - Stronger than expected economic performance in 2007; Weekly economic data preview - Bank of England and ECB likely to keep interest rates on hold

Economics Weekly  7 January 2008

Stronger than expected economic performance in 2007

Once again, a year of surprises
As we start 2008, not all of the economic data for 2007 are in yet but it is worth reviewing how the year went. One way of doing this is to compare consensus expectations for key economic data made at the start of 2007 (based on forecasts made in December 2006) with those at the end of the year. The results are somewhat surprising: growth was stronger in 2007 than was expected, and inflation and interest rates were higher. This was despite oil prices roughly doubling and the sub prime crisis breaking out from August onwards. The latter event meant that the dollar fell against most currencies in 2007, as the US sits at the epicentre of the financial market turmoil that was sparked by rising defaults rates in US sub prime mortgage loans that are in many structured products used as collateral in credit markets.

Table 1 shows that the biggest faller against the US currency last year was the Indonesian rupiah, with a drop of 4.3%. Although the UK pound rose by 1.3% against the US dollar, it is still in the top ten fallers, because the size of the depreciation of the dollar was so large and widespread. Interestingly, this does pose the question of whether expectations for US growth and inflation in 2008 are too low, as a weaker currency implies that growth may be faster but inflation higher.

Economic growth above expectations because of the emerging economies…
The main economic growth theme of 2007 was that global activity once again exceeded expectations – it did the same in 2006 - but inflation was also higher than predicted, see chart a. The general pattern is that growth in the emerging markets was higher than expected and growth in the developed economies was weaker than expected. However, of the major economies, growth was higher than expected in the UK and EU but less than expected in the US and Japan – the latter two being the world’s largest economies. But it should also be noticed that the extent of the growth outperformance of the US and EU economies was greater than the underperformance of the US and Japan, see chart b. Growth in the UK was expected to be 2.4% in 2007, instead it is likely to be 3.1% (0.7 of a percentage point better) and for the EU 2.6% growth against an expectation of 2% (0.6% better). For the US, the expected outturn for 2007 is now set at 2.2%, just 0.1% below the 2.3% expected at the start of the year. For Japan, the figures are 1.8% expected now, against 2.0% at the start of 2007. But the real reason for faster than expected growth in the world economy in 2007 was the emerging markets, where activity was strong for a broad range of countries, from oil exporters, (perhaps no surprise given the rise in oil prices that took place), but to countries in Asia, Latin America, Africa and the Middle East.

…and so global inflation was higher as well…
Price inflation was higher than expected in all of the world’s major economies last year - except Japan where deflation still has a grip - and in the emerging markets generally. The reason for higher than expected price inflation is clearly faster than expected economic growth, in particular that in the emerging markets. In other words, the world economy is operating close to or above its long run potential, a positive output gap that usually generates upward pressure on price inflation. This has led to a rise in demand for a range of commodities to fuel the faster pace of expansion – metals spring to mind. But higher living standards in emerging markets has also led to a change in tastes and a rise in demand for a range of goods that is also leading to higher inflation in food and some other items. Short term interest rates in this environment would have been expected to be higher than expected and in many countries, though not all, were indeed higher.

…but the credit crisis has meant that the financial market response has been mixed
The credit market crisis in the second half of 2007 resulted in short term interest rates in the US being cut by 100 basis points from the 5.25% peak reached earlier in the year, ending the year lower than was expected at the start, see chart d. The UK and Canada joined the Fed in easing monetary policy in December. But despite this, short term interest rates in these two economies still ended the year higher than was expected at the start of 2007, owing to stronger growth and higher inflation. Interest rates were also higher than expected in the EU, see chart d, where official short term interest rates have not been cut despite the continuing credit market turmoil.

Despite faster than expected growth and higher than expected inflation, bond yields have ended up lower in all of the major economies, except the EU, see chart e. The reason, of course, is almost certainly the result of the credit markets crisis, which has led many in the financial markets to look for a weaker economic outturn in the year ahead as credit is curtailed by banks that are short of capital to lend. This is set to be a major theme of the global economy in 2008. But despite all of the pressure created by the credit crisis, equity markets in the major economies ended 2007 higher than they began the year, as the rise in global growth buoyed profits and company earnings, see chart f. Equity markets performance in the emerging markets was even stronger than in the mature markets and is yet another theme for 2008. Will the emerging markets be able to outperform the developed economies in terms of growth and corporate earnings for a second year or is the decoupling in 2007 merely a one off event?

Trevor Williams, Chief Economist

Weekly economic data preview

Bank of England and ECB likely to keep interest rates on hold

Interest rate decisions in the UK and the euro zone head up the economic calendar this week. We expect both the Bank of England (BoE) and the European Central Bank (ECB) to keep interest rates on hold at 5.50% and 4.0%, respectively. UK data due this week features house prices, foreign trade, industrial output and BRC retail sales. A quiet week in terms of US releases will leave market participants to mull over the employment and confidence data published last week. Fed speakers will assume most of the spotlight in the days ahead and this will help to shape expectations on the outcome at the next Fed FOMC meeting at the end of the month.

• A stronger than expected outcome for the UK services PMI last week and the decline in UK Libor rates from the December highs are behind our forecast for no change in the base rate on Thursday. The 0.25% rate cut to 5.50% in December was a pre-emptive move by the BoE to counter downside risks to the economy from the financial market turmoil. Since then, UK libor rates have sharply fallen back, thanks to the coordinated central bank intervention halfway through December. This has lead to a narrowing in the UK Libor spread over base rates and has effectively taken off some pressure for borrowers. The spread for 3-month Libor over the base rate fell last week to 29bp, the lowest since money markets seized up at the beginning of August 2007. The fact that financial market turmoil has not worsened means that downside risks to the economy have not intensified since the BoE cut rates in December. This was underlined last week by the rise in the services PMI to 52.5 in December. Even though business conditions in the economy have reportedly become more challenging and mortgage lending has slowed, this has not been accompanied by an easing in inflation pressures. This will keep policymarkers at the BoE on alert and should favour no change in the Bank's strategy on Thursday. The Bank made clear in the minutes of the December MPC meeting that 'a large reduction in Bank Rate now would increase upside risk to inflation'. With oil hovering around $100 and sterling down 4.5% on the trade weighted index since last month, we believe chances of a second consecutive rate cut this month are under 50%. Incoming data on the UK economy in the coming weeks will provide a clearer picture of output growth and inflation at the end of 2007, and this will help the Bank to update its projections for the economy and interest rates in the Quarterly Inflation Report in February, making a rate move more likely that month. Data this week includes the retail sales monitor from the British Retail Consortium on Tuesday, foreign trade on Thursday and industrial output on Friday. The Halifax is scheduled to publish its latest house price figures during the week. Chancellor Darling will testify to the Treasury Select Committee on Thursday on Financial Stability and Transparency.

• A relatively quiet week for data watchers in the US will offer participants a chance to mull over the Fed minutes, the December employment report and business survey statistics published last week. Fed speakers are likely to overshadow data releases of initial claims on Thursday and foreign trade on Friday, as market participants look for guidance on the trajectory of US interest rates at the next Fed FOMC meeting on January 29th and 30th. A slowdown in the rate of employment growth and a marked deterioration in the growth prospects of manufacturing and services in December bolstered market speculation that the Fed will have to consider lowering rates to 4.0% at the end of the month.

• The ECB is forecast to keep interest rates on hold at 4.0% on Thursday, and re emphasize during the press conference that the elevated rate of CPI inflation and M3 money supply growth continue to argue in favour of a hawkish stance. Data last week showed that CPI was unchanged at 3.1% in December, well above the ECB's 2.0% target. Annual M3 money supply growth was stable at 12.3% in November. We are still of the view that the ECB may have to raise interest rates this year to bring inflation back to target by the end of 2008 and in 2009. The highlights of a packed euro zone calendar this week include retail sales and business confidence.

Kenneth Broux, Economist

Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500

Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.



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