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Economics Weekly – Interest rate cycles compared – only modest signs of credit crunch? Weekly economic data preview - Bank of England Inflation Report to highlight upside risks

Economics Weekly 12 May 2008

Interest rate cycles compared – only modest signs of credit crunch?

Little sign of credit crisis in this rate cycle...
There has been a lot of debate about the impact of the credit crisis on the UK economy, with any new sign of weakness in economic data automatically laid at its door. We will not attempt in this piece to try and disentangle whether weakness in the economy is due to the credit crisis or to other factors. But it might be useful to compare the evolution of a number of key economic variables in the current interest rate cycle (we define a cycle as a move from one trough to another) in the UK with the previous cycle.

The question then is: is the path of key variables in the current rate cycle significantly different from that of the last cycle? If they are, we could draw some inferences about why this may be - perhaps the credit crisis if they are significantly worse - as well as make observations about whether the economic impact of the current interest rate cycle is more or less severe than the last one. Since there are an almost infinite number of variables we could look at we have used the economic indicators that we think are most informative, including, inflation activity, and monetary data.

...interest rates are still above the last peak, even though they have been cut
In the last interest rate cycle, bank rate was raised from a trough of 3.5% in 2003 to a peak of 4.75% and then left there through to August 2005 when it was cut by 0.25% to 4.5%. In the current cycle, rates were raised from 4.5% in August 2006 to a peak of 5.75% last year with cuts starting in December. The current bank rate of 5% is therefore 1/2% above the peak reached in the last interest rate cycle. Clearly this must be down to greater inflation pressures,as the credit crisis would imply lower interest rates than the current rate.

The reason is that inflation is higher now than in the last rate cycle
Chart a shows that consumer price inflation has remained higher over the entire period of this base rate cycle than in the 2003 to 2005 cycle, though both seem to have a similar pattern in that there has been a fall from a peak to a trough followed by a rise. The problem is that the increasing trend being shown by consumer price inflation in the current phase of this rate cycle is from a much higher level than in the last interest rate cycle. The good news though is shown in chart b, which is that wage inflation is very subdued in the current rate period relative to the last one. In fact, since economic growth started losing momentum in the second half of 2007, wage inflation has almost immediately slowed down as well. It is not clear why this should be so, although a clue may be in the fact that the influx of migrants from Eastern Europe has occurred during the current interest rate cycle. Moreover, unemployment is also currently lower than in the period November to 2003 to August 2005, see chart c, making it even more remarkable that wage inflation remains so weak. Despite the fact that wage inflation is lower than in last rate cycle, volume growth of retail sales is higher as is manufacturing output growth, see charts d and e – both of which may also help explain why price inflation is higher. So far it has to be said that none of these charts suggest that the credit crisis is impacting the UK economy particularly hard, though it may admittedly be too soon to be sure.

Monetary data show few effects from the credit crisis...
What about the monetary data? M4 money supply growth is currently faster than that in the last rate cycle, as should perhaps be expected given that inflation is higher and retail sales and manufacturing output growth faster. Despite the worry about the economic side effects of recent falls in house price inflation, on the official data there does not appear to be much of a difference between the current deceleration in house price inflation in this rate cycle compared with the last one, see chart f. In fact, house price inflation is currently a little higher than in the 2003 to 2005 interest rate cycle. Mortgage and credit lending growth is slightly weaker in the current cycle than in the last one (charts not shown), but not by much. However, the housing data offers the strongest evidence of any effect from the credit crisis, which has seen libor rates remain higher than normal against base rates, amid the withdrawal of a range of mortgage offers. The spread between 3 month libor and bank rate so far this year has been 52 basis points, well above the 16 basis point average during the 10 years previous to the onset of the credit crisis last June.

...but is it turning up in some mortgage data?
The final chart, g, looks at mortgage approvals, which should reflect the withdrawal of offers in the current rate cycle compared with the last one. This chart does indeed show that this rate cycle is having a worse impact on approvals than the last one, although interest rates are higher and so one would have expected approvals to fall back more sharply, especially since the chart also shows that they took a long time to fall back in this rate cycle compared with the last one. Nevertheless, this does suggest that the credit crisis is having a unique impact, and that there may be worse to come. However, on balance, the economic data we have looked at would not suggest that the reaction to the current rate cycle is significantly worse than in the last cycle, except that growth and inflation appear rather more robust. But, the credit crisis complicates this analysis, as the possibility remains that its full negative effect has not yet come through to the economy. This makes the job of setting interest rates for UK economic conditions even more challenging than usual.
Trevor Williams, Chief Economist, LTSB Corporate Markets


Weekly economic data preview W/c 12 May 2008

Bank of England Inflation Report to highlight upside risks

The UK Inflation Report is due this week and will take the lion share of attention as we look for the BoE's updated projections for growth and inflation. UK economic data features consumer prices and employment. Our forecast is for a rise in annual CPI to above 2.5% in April. It is a busy week too for US indicators where releases of retail sales and consumer prices data for April may indicate that sales are resilient and inflation is still worrying. A litany of Fed speakers may drop some hints on how close US interest rates are to a bottom. The preliminary Q1 gdp estimate will be published in the euro zone and may show that growth stabilised at 0.4% q/q compared to the final quarter of 2007.

• A busy week for UK financial markets lies ahead as the BoE prepares to publish its quarterly Inflation Report on Wednesday. The report compiles the Bank's forecasts for inflation and economic growth, based on a number of assumptions. A revision of the February forecasts appears on the cards as the Bank takes stock of a number of economic variables released since the last Report. The 35% jump in crude oil prices and higher food prices stand out and may lead the Bank to change both its forecasts for growth (down) and inflation (up). The fact that the logjam in money markets has not been resolved, and that 3-month Libor has actually drifted up over the past quarter - although rates have come off their highs since the start of Q2 - is likely to dampen domestic demand and could persuade the Bank to publish a more downbeat outlook for gdp growth. The Bank of course last week kept base rate on hold at 5.0% and it will be interesting to hear from governor King how he believes the economy will develop, based on the implied market interest rate of 4.75% (July forward Sonia). Sentiment towards a rate cut in June firmed following the release of a weak services PMI survey last week - the index fell to a 5-year low. This scenario may be tested on Wednesday, but also on Tuesday when inflation data for April will be published. Annual CPI was unchanged in March at 2.5% but is forecast to have resumed an upward path in May. We forecast a rise to 2.6/2.7%, a 12-month high. Based on our forecast of a rise in CPI above 3.0% later this year, the chart below shows how CPI may catch up with the Bank's own inflation expectations. This should limit the Bank's ability to cut interest rates. Unemployment data is due on Wednesday prior to the Inflation Report. The fact that unemployment has remained low and that the private sector is still adding jobs reinforces our view that the slowdown in economic activity and the decline in house prices should be limited in magnitude. Other data releases this week include producer prices and foreign trade on Monday, and house prices on Tuesday.

• A busy calendar shapes up in the US where we will concentrate on retail sales and consumer prices. Both releases are for April and we expect stronger retail sales to help underpin gdp growth at the start of Q2. Record petrol prices and falling house prices will probably sap consumer confidence, but this has to be balanced with the fact that the labour market is no longer deteriorating and the $180bn tax credit which may offer positive impetus. Even though one can expect discretionary spending to stay weak, the fall in the unemployment rate to 5.0% in April gives reason to believe that some retail categories should hold up. The retail sales data are due on Tuesday. The latest CPI inflation figures are due on Wednesday and our forecast suggests that inflation is likely to have edged up in April to 4.1% (headline) and 2.5% (core, i.e. excluding food and energy). A long list of Fed speakers will draw close scrutiny as markets weigh up the probability that US interest rates may have bottomed, and to what extent the FOMC could be split on the future course of action as worries persist about elevated inflation and inflation expectations.

• The ECB last week kept interest rates unchanged at 4.0% and president Trichet gave not the faintest indication that interest rates will be changed anytime soon. Inflation data from the euro zone is due on Thursday and even though a decline to 3.3% in April is pencilled in, the likelihood is that inflation could re-accelerate. The preliminary Q1 gdp estimates are due from Germany and France on Thursday and are  forecast to show that growth resisted the downward pressures from oil and the credit market turmoil.
Kenneth Broux, Economist, LTSB Corporate Markets

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

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