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Economics Weekly - Is inflation the main risk to economic growth? Weekly economic data preview - Minutes of BoE and US Fed interest rate setting meetings feature

Economics Weekly W/c 19 May 2008

Is inflation the main risk to economic growth?

Bank of England warns, people listen but inflation over the next two years is now largely out of its control...
Sometimes it takes the central bank to speak in order to get people to take notice of events that others might also have spotted but the majority have missed. So it was with the latest Quarterly Inflation Report (QIR) from the Bank of England. A few observers had been warning that the main risk facing the economy was not the credit crunch, important though that is, but rising price inflation. This reasoning was based on a view that the credit crisis had mainly hit the developed markets and within them those with firms that had been most heavily involved in securitised products. But outside of these firms - the credit derivatives part of the financial markets and those closely related to it, including the housing market - other sectors were not doing too badly.

Importantly looking ahead, global growth is not being driven by developed economies but the populous emerging market giants of India, China, Brazil and Russia and a range of other emerging economies. The take off in their growth rates in the last decade, and the resultant demand for the metals and energy necessary to fuel that expansion and the effects of rising living standards on the demand for food, means that a range of commodity prices are rising sharply and likely to remain high for the foreseeable future. Further, instead of responding to this crisis by opening markets and allowing freer trade in these goods so that supply increases and price inflation eventually fall back, the tendency seem to be to protect markets, which would drive up prices as shortages arise.

...does this make the inflation risk greater than the risk from the credit crisis?
So although economic growth will slow in the developed countries and some economies could perhaps go into or skirt recession, like the US and UK, the main risk may not be from the credit crisis but from cutting interest rates too deeply to try and prevent the slowdown. This would risk embedding inflation into the economy in the same manner that occurred in the 1970s after the first oil price shock, and which persisted for about 25 years before being brought back under control from around the mid 1990s, see chart a. Hence, as MPC Governor Mervyn King said, a slowdown is necessary to bring inflation back to the 2% target in the medium term and “monetary policy cannot, and should not try to, prevent that adjustment”. This analysis is not to downplay the effects of the credit crisis, since the widening of spreads and the continued high level of LIBOR will weaken economic growth by more than otherwise would be the case, but it does not have the same potential to derail global growth for decades to come as does the risk of letting inflation run out of control.

Inflation rise shocks, as Bank of England warns it could remain above target until 2010
In the latest QIR, the Bank sets out the fact that despite weakening growth, it could not cut interest rates because of the risk of raising inflation further. It also accepted that inflation would remain above its 2% target for perhaps two years, and above 3% for over a year. Indeed, the Governor of the Bank of England suggested that he would have to write several letters to the Chancellor, as inflation would be at 3.1% or above for several months and that triggers an open letter explaining why it happened, what he is doing about it and when it would get back to target. In a sense, the comments at the press conference after the release of the QIR were a dress rehearsal of the contents that will be in such a letter. Since he also said that it was too late to try to get inflation back quickly to target, as the costs in terms of lost output at a time of weakening growth could not be not justified, this means that base rates will not be raised despite high inflation. Hence, the likelihood is that several letters will need to be written On our monthly forecast, see chart b , the UK’s annual consumer price inflation will remain above 3% until early 2009, after rising to 3.1% possibly as soon as May 2008, and remain above 2% throughout most of next year.

UK Inflation driven by overseas factors but also by domestic growth...
But the key lesson is perhaps to not pay too much attention to the point estimates in the QIR, it did not foresee the surge in price inflation in March and its forecast always has inflation falling back to target in two years’ time (see charts c and d), but to focus on the medium term pressures that are driving global inflation trends. These suggest that the risk is of a rise in interest rates, not a cut. If, for instance, the Bank of England is wrong about the downside risks and growth is not as weak as they are assuming, does that mean that inflation rises further above 4% and remains above the 2% target for even longer? And, if this is the case, does this change the risk profile to a rise rather than a cut in base rates next year?

...so is there still a risk of a rate rise?
A key danger often overlooked is that economic growth turns out to be stronger than expected and inflation moves higher, requiring a rise in base rates to make sure that growth is weak enough to partially offset the rise in inflation from global growth pressures. Further, one reason too often ignored is that UK price inflation is not solely driven by overseas factors, but from domestic demand as well. Growth has been stronger than the capacity of the UK economy to meet it from home-produced goods for many years and this has turned up in a widening trade and current account deficit. But a fall in the currency, as a result of this trend, now means that imported price inflation is being given a push up by a 13% fall in the trade-weighted index in the past year (equivalent to a cut in rates of about 3-4% according to one MPC member).

Trevor Williams, Chief Economist, LTSB Corporate Markets

Weekly economic data preview W/c 19 May 2008

Minutes of BoE and US Fed interest rate setting meetings feature

UK data in the week ahead may indicate that the economy is currently in better health than is assumed, although this is unlikely to significantly lift pessimistic perceptions about future economic performance. As far as the data is concerned, we think there is a risk of an upward revision in Q1 GDP to 0.5% from 0.4%, M4 money supply growth of 12% in April and retail sales growth above 4% on an annual basis. In addition, the minutes of the 7-8 May interest rate setting meeting are published on Wednesday - we expect an 8-1 vote for no change, with David Blanchflower the single dissenter. The vote is likely to have been heavily influenced by the MPC's access to the April CPI growth figure of 3% and producer price growth of 7.5%, which would also have also wiped out the possibility of another 0.25% cut in bank rates next month. May's key German ZEW survey of economic sentiment and the IFO survey of the business climate will be keenly assessed for clues that economic performance could surprise to the upside in Q2 as was the case in Q1. In addition, minutes of the US Fed's interest rate setting meetings will show the extent of support for reducing interest rates by 0.25% to 2% at the last meeting and the likelihood of more rate cuts to come. The BoJ is expected to again hold interest rates at 0.5% on Tuesday, despite surprisingly strong Q1 GDP growth and accelerating CPI inflation.

UK inflation data featured heavily last week, while the focus of data this week is more on growth. Whereas April's forecast M4 money supply growth rate of around 12% is below last May's peak of 14%, it is more than double the nominal GDP growth rate of around 5%, supporting economic growth as well as presenting a risk to inflation. M4 sterling lending may also have held up well at £16.8bn in April, compared with £17.4bn in March. Public finance data for April, the start of the fiscal year, is published at the same time. April BRC survey like-for-like sales were weak, suggesting that there may be a second consecutive monthly decline in the level of official sales compared with March. But on an annual basis, retail sales growth is robust at 4%, well above the long-term average of just over 3%, driven partly by strong expansion of mail order and internet-only sales. The CBI industrial trends survey may show an improvement in sentiment in April, buoyed by exports, although the net confidence balance is likely to remain in negative territory. Finally, on Friday, the second estimate of Q1 GDP may be revised up from 0.4% to 0.5% growth on the quarter, with the details of the report, highlighting the contribution made from consumer expenditure, investment spending, government expenditure and net trade.

• The US Fed publishes the minutes of its 29/30 April FOMC meeting on Wednesday evening, which will inform on the extent of support for the 0.25% cut to 2% in Fed fund's rate and give clues as the potential level of support for another cut next month. This week's data is likely to highlight the central bank's dilemma - April headline and core producer prices are expected to rise strongly, by 6.9% and 2.9%, respectively, while existing home sales levels may weaken below the January low of 4.89m. The positive housing starts and buildings data for April published last Friday, may increase the possibility of a surprise rise, which may be interpreted as a sign that the Fed is more likely leave rates unchanged at 2% rather than make further cuts.

• Eurozone data may support the view that the economy is proving more resilient than expected to the strain of the loss of price competitiveness from the strong euro and tighter credit markets. The two key German surveys, the ZEW and the IFO surveys will provide useful insight into the likelihood that firm economic growth was or was not sustained into Q2. Other key data include flash May manufacturing and services PMIs - we expect both to show survey levels above 50 indicating expansion.

Nichola James, Senior Economist, LTSB Corporate Markets

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