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Tuesday May 27, 2008 - 10:54:22 GMT
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Economics Weekly - High inflation will slow UK economic growth but no recession; Weekly economic data preview = Is record oil price hitting consumer confidence?

Economics Weekly

High inflation will slow UK economic growth but no recession

Price inflation to reduce economic growth this year
We are more concerned about inflation than recession but a rise in inflation weakens real, or inflation adjusted, growth. To this extent, accelerating price inflation may raise the risk of recession (falling output) or a period of well below long run average economic growth. How does price inflation do this? The process is straightforward, inflation reduces real incomes and so cuts real consumer spending. With UK economic growth already weakening sharply - how much will the latest bout of rising prices damage prospects? The conclusion from the following analysis is that higher price inflation will take 0.25% off gdp growth this year but will have no impact on our 2009 forecast, if it falls back as expected. We now look for 1.8% growth this year after 3% in 2007.

UK economic growth is slowing but is a long way from recession
Annual UK Q1 gdp growth was unrevised from the preliminary estimate, of 2.5% and 0.4% q/q. The breakdown of the expenditure components showed consumer spending rose by 1.3%, up from just 0.1% in Q4, but gross fixed capital formation fell by 1.6%. There was a strong positive contribution from net trade (exports minus imports), though primarily reflecting weaker imports rather than higher exports. The data confirm that the UK economy performed better than many expected in Q1 and we expect this trend to continue further into the year, resulting in annual average growth closer to 2% than 1%. Chart a shows the consensus view against our own - there is in fact no great difference for this year but there is a sharp divergence in 2009, where we expect growth to rise but the consensus forecast a further fall. What is puzzling for some is that anecdotal data are currently showing a weaker growth trend than the actual data are exhibiting and that the resilience of consumer spending is at odds with the sharp falls seen in confidence and surveys of retail sales. We believe the explanation lies in a continued strong UK labour market, but our focus in this Weekly is on the link between inflation and growth not on why consumer spending has not yet collapsed.

The consensus view is of continued UK economic growth, albeit at a slowing pace
As noted, the average UK forecast for 2008 is for economic growth of 1.7%. Interestingly, this is a little stronger than the average rate implied in the Bank of England Inflation forecast, which is for 1.5% growth (with a risk of two consecutive quarters of falling output or recession). But should actual economic growth turn out to be close to 1¾% this could have implications for inflation trends and interest rates by adding upward pressure to both. The reason is that a slowdown in growth is required to get price inflation back to target over the next few years. And so actual signs of a slowdown should not be taken as indicative of imminent interest rate cuts by the Bank of England. This may happen, but only if the economy slows below the already weak rate the MPC is expecting for 2008. Indeed, there is a risk that if growth does not slow as much as the MPC is expecting and inflation turns out higher then the risk is that the central bank must raise interest rates. This may be what is being priced into SONIA (Sterling Over Night Index Average) rates, which imply a rise in base rates to 5.25% by September, or at least a 50% risk that this occurs.

This is of course at odds with fears for growth that focus on the downside risks from the credit crisis. This is undoubtedly a real risk, as credit standards are tightened, banks are strengthening balance sheets and both charging more for loans and making them less available, meaning there is a real risk that growth could slow sharply, but there are also other concerns. Key amongst them is accelerating price inflation, chiefly caused by a shift in relative global prices (from consumers of commodities to producers of them) that in reality cannot be addressed with interest rates. But another reason why inflation is rising is that UK domestic output growth has been insufficient to meet domestic demand for a few years, reflected in a widening trade deficit. This can be described as a positive output gap, which on our data is only just turning negative and is required to ensure that price inflation decelerates back to 2% in the next year or so. A positive, and rising, output gap is associated with accelerating retail price inflation and vice versa.

What impact will the rise in price inflation have on consumer spending?
Charts b, c, d and e show our calculation of the direct effects of higher inflation this year (we had been looking for 2.8% CPI inflation on average but on the release of the latest inflation data this has been raised to 3.1%) on the UK economy. The consumer spending deflator is higher, real disposable income is lower, so real spending is weaker, and hence real gdp growth falls by more this year than in our earlier forecast. In specific terms, our growth forecast falls back to 1.8% from just around 2%. But there is little change to next year’s outcome, as inflation falls back as expected to just above 2%. In fact, the annual price inflation forecast shifts up from 2.2% next year to 2.3%, not a discernible difference.

But with these growth rates, the Bank of England is unable, in our view, to cut interest rates again in 2008. The MPC is also worried that wage inflation could rise at a time that price inflation is hitting new peaks. It is highly unusual for such a large negative gap to open up between wage inflation and price inflation (wage inflation usually rises faster than price inflation). Interestingly though, if wage inflation does stay low, and given the fall in the exchange rate, stronger growth in 2009 becomes even more likely as it makes UK exporters become more competitive in global markets, just as they were after the exit of sterling from the Exchange Rate Mechanism in 1992 that was followed by an export boom. But we would not be surprised to see more workers fight to get higher pay increases this year, given the rise in price inflation. This largely explains the rationale behind our forecast that the next move in Bank rate is more likely to be up rather than down, though in 2009. As the economy recovers, base rates will have to rise to moderate the upturn so that a positive output gap does not reappear.

Trevor Williams, Chief Economist, LTSB Corporate Markets


Weekly economic data preview W/c 26 May 2008

Is record oil price hitting consumer confidence?

A relatively quiet week lies ahead for the UK where house prices, consumer confidence and the latest CBI distributive trades survey will be published. The Q1 gdp data released last week showed that personal consumption growth accelerated in Q1, despite weak survey data. This week's CBI survey may again show that households are cutting back in the face of record fuel prices and lower house prices. The British Bankers Association (BBA) will publish its annual review of Libor rates on Friday. House prices and personal spending are also due in the US. Euro zone inflation is forecast to have accelerated in May from 3.3% in April. Interest rates in Norway are forecast to stay at 5.5%.

• A dramatic shift has taken place in UK interest rate expectations this month and the adjustment continued last week, as gilt yields and swap rates rose by a whopping 40bp. This is a reflection of the rise in actual inflation and the fact that households and the financial markets have marked up their inflation expectations since the start of Q2. This is the message from our latest LTSB Consumer Barometer, of which more details will be published on Friday. For the Bank of England inflation is the principal challenge for monetary policy, a point reiterated by MPC member Sentance last Friday. With the Q1 gdp data last week painting a rather resilient picture of household consumption - spending rose 1.3% q/q in Q1 vs 0.1% q/q the previous quarter - we wonder whether the sharp downturn in spending and the broader economy, central to the BoE's latest Inflation Report - will be as severe as projected. This week is unlikely to bring much evidence

of weaker spending. Despite the relentless rise in fuel prices and housing market pessimism, anecdotal evidence from UK retailers suggests that high street sales may have rebounded in May after declines in March and April following a spell of good weather. This explains why we expect the CBI distributive trades survey, due on Thursday, to have improved to -20 in May from -26 in April, underpinned by a slightly less pessimistic balance of reported and expected sales. The Nationwide is expected to release its house price figures for May during the course of the week. More expensive rates of borrowing and dwindling mortgage offers mean that the building society may report a 7th consecutive fall in prices. The BBA is on Friday scheduled to publish its annual review of the Libor setting process. The review will draw a greater than usual degree of scrutiny due to the high level of Libor in respect to Base rate, and may propose recommendations to the participating institutions on how to improve the accuracy and transparency of the daily rates.

• A busy week for US indicators is forecast to reveal a further fall in house prices. The Case/Shiller index for March, due on Tuesday, reported an annual decline of 12.7% in the 20 largest metropolitan areas in February. A rising rate of foreclosures coupled with a high level of housing stock mean that further price declines are probably inevitable. Consumer confidence for May is also due on Tuesday and is forecast to have stabilised following the decline in April to a 5-year low. Q1 gdp data on Wednesday may be revised upwards following better foreign trade figures for March. Last week, the Fed revised down its forecast for 2008 and it now expects growth to average no more than 1.2%. Personal spending and inflation data for April will be released on Friday. We expect the core PCE deflator, the Fed's preferred inflation measure, to have edged up to 2.2% from 2.1% in March. Inflation expectations in the US have also risen quite sharply in recent weeks (see chart, break even rate), and this could lead Fed speakers this week to reiterate that lower US interest rates are not currently planned.

• Euro zone swap rates and yields rose sharply last week as fears intensified about the rise of inflation and the response of the ECB. Higher consumer prices for food, petrol and transport may have pushed up annual CPI back above 3.3% in May, setting the tone for the months to come. The CPI data will be released simultaneously with the confidence surveys from the EC. The flash PMI's for May last week showed a decline from April, led by a larger than average drop in the services sector. This added to the view that the economy is probably experiencing a slowdown in Q2, a message that the European Commission is likely to back up on Friday. However, the persisting inflation threat means that interest rates will stay on hold.

Kenneth Broux, Economist, LTSB Corporate Markets

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


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