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Economics Weekly - UK inflation expectations take-off makes cutting rates difficult; Weekly economic data preview - Interest rate decisions by the BoE & the ECB featur

Economics Weekly

 UK inflation expectations take-off makes cutting rates difficult

Inflation expectations are rising…
A worrying aspect of the recent rise in actual inflation in the UK has been the accompanying rise in inflation expectations. Expectations matter for actual inflation. The reason is twofold; first, if companies believe that inflation is likely to remain high, they are more willing to raise their prices and to pay workers more. Second, if consumers believe that inflation will remain high they are more likely to accept price rises and to push for higher wages to compensate them for a loss of real purchasing power. A sharp rise in price inflation has destructive economic effects; it makes companies less likely to invest, as they demand a higher rate of future profit growth (to compensate for inflation) to justify investing today. This means weaker economic growth, resulting from weaker employment and higher unemployment. Moreover, those on fixed incomes are likely to suffer more, as they are unable keep up with inflation eroding their real income, so poverty levels are likely to rise and put upward pressure on public spending.

…this is worrying for economic growth as high inflation means less investment and weaker consumer spending
Yet another negative from rising inflation is that it makes the average level of interest rates in the economy higher than it would be otherwise. This is true for short term interest rates and long term interest rates, so compounding a weaker growth trend. If inflation expectations are anchored on a central banks’ price inflation target, for instance, it means that the actual rate of interest required to keep inflation, and the economy, stable, is lower than if inflation is high and unstable. This may seem obvious but it is a lesson that has taken policy makers around the world many years to learn. Of course, long term interest rates matter for an economy – if not more than short term rates - and they are not in the purvey of government. In that case, the worry is that those with an investment paying a fixed rate of interest (or, in other words, a fixed nominal amount) will receive less in real terms in future the higher is the rate of inflation. This not surprisingly means that these investors will demand a higher rate of interest to compensate for the erosion of future real returns by accelerating inflation, meaning the price of fixed rate bonds fall.

Expectations are now higher than when the Bank of England was made independent in 1997…
Chart a shows that 10 and 20 year break even inflation rates (nominal yields minus index linked) have jumped up sharply in the last few months and are now the highest they have been since the Bank of England became independent in May 1997. This must be very worrying for the central bank, as it implies that it has lost inflation credibility, in other words, investors no longer believe that it can keep inflation low and stable. The chart shows the sharp fall that occurred in these rates in 1997 when the Bank was first made independent. Thus higher inflation expectations carry a potential economic cost, as higher long term bond rates will keep upward pressure on mortgage rates and company bonds, so weakening economic activity more than intended by the Bank of England. Moreover, households/consumers are more sceptical about inflation than at any time in our survey, see chart b and perhaps more worrying, on the Bank of England’s own NOP survey that has been carried out since 2000, see chart c. The aim of the latter was to see whether the MPC was keeping inflation expectations low and stable around the inflation target, in other words anchored. On this basis, they can be said to have failed.

…as actual inflation is already at 3% and an acceleration to 4% is likely in the months ahead
But the reason for the sharp rise in inflation expectations is not a surprise, given that actual annual CPI inflation is now at 3% relative to the 2% inflation target. Moreover, our own inflation forecast suggests that it will get to a peak of about 4% later in the year, see chart d. This means that official interest rates in the UK will have to remain higher for longer. Whether price inflation then falls back in 2009 as expected will partly depend on factors beyond the central banks’ control, like the rise in imported price inflation and global commodity price pressure. Chart e shows that imported inflation is closely correlated with the rise in domestic UK firms’ output prices and with the rise in CPI inflation. To that extent, though, the burden of getting overall inflation down implies that there will have to be a squeeze on domestic inflation. But chart f shows that this means that the level of economic activity must fall further, i.e. growth must be below its long term trend, in order to bear down on overall price inflation.

This makes cutting UK rates highly unlikely even if growth slows sharply unless accompanied by a fall in inflation expectations
What this means is that sub trend UK economic growth does not mean that UK interest rates will fall as many expect in 2009. Any rate cuts are likely to depend on overall inflation falling back to about 2% in 2009, or at least expected to fall back to that rate. This will be a tough challenge, as with consumers real incomes being squeezed by earning growth running below price inflation, see chart g, the risk is that people start demanding faster pay growth to compensate for the loss of real earnings, as they did in the 1990s. More worrying for the MPC is that high inflation expectations may make workers more likely to make such demands as they no longer believe as much that the central bank will keep inflation down. So cutting interest rates without there first being a fall in inflation expectations will be a big risk for the MPC to take.
Trevor Williams, Chief Economist, LTSB Corporate Markets

Weekly economic data preview W/c 2 June 2008

Interest rate decisions by the BoE & the ECB feature

Weak Bank of England mortgage lending and approvals data and May PMI manufacturing & services surveys will provide justification for the MPC to hold rates at 5% at its interest rate setting meeting on Thursday rather than raise them, despite serious concerns about accelerating CPI inflation. While flash eurozone CPI climbed to 3.6% in May, raising the chances of a hike in ECB interest rates from 4%, it will not happen as soon as this week, due to concerns over slower economic growth and destabilising the financial sector already hit by the credit crisis. US economic indicators are likely to suggest that the Fed stays on hold as US ISM manufacturing & services business surveys for May are unlikely to improve significantly, while the key NFP employment figure will probably show another small fall in jobs. The Reserve Bank of Australia (RBA) is expected to leave interest rates on hold at 7.25% at their policy meeting on Tuesday, as evidence of a fall in consumer borrowing suggests that tight monetary policy may be having the desired effect.

• Concerns over the UK housing market slump grew last week as the Nationwide house price index for May declined at a monthly rate of 2.5%, the largest fall since the index began in January 1991, representing a 4.4% fall on an annual basis. Also, April's BBA mortgage approvals, which give early indication of the full market data due this week, were higher than in March, but sharply lower than a year earlier. Mortgage approvals were at 58,000 in April, well below the 64,000 recorded in March and the lowest on record. Net mortgage lending was £6.4bn in April compared with £6.7bn in March. These numbers are likely to hit already weak consumer confidence and suggest that retail sales cannot remain as strong as they have been recently. The manufacturing PMI came in at 50.0 and we expect the services PMI to also remain above the 50 level, indicating expansion, but given rising input costs and worries about higher numbers of insolvencies, there is a risk that business confidence in May weakened further.

• An ECB report suggesting a growing bias towards raising interest rates was given justification by Friday's publication of May flash CPI inflation growth of 3.6% compared with 3.3% in April, the highest level on record. Although our central view is that the ECB will hold rates at 4% on Thursday, President Trichet may prepare financial markets for a coming hike in his subsequent press conference, but an actual rise is unlikely. The problem remains that despite the fact that confidence among German companies was more upbeat in May, evidenced by a strong German IFO survey, growth prospects in much of the rest of the eurozone are weak and the credit crisis is in full swing. Eurozone retail sales data, published on Wednesday, may show positive growth on the month, but a lower level of retail activity on an annual basis.

• The US ISM services employment report and the ADP employment change figure may provide clues as to the outcome of the key NFP jobs number due Friday. We anticipate a jobs loss of 45,000 last month, compared with a loss of 20,000 in April, bringing the cumulative loss to around 300,000 this year. In addition, the unemployment rate may have increased a touch to 5.1% of the workforce. But on a more positive note, average earnings may have grown at an average annual rate of 3.4%, helping support consumer spending. Also, we expect May's ISM manufacturing and services confidence indices to improve slightly compared with April. Other data are likely to show construction spending falling further. Nonetheless, last week's publication of an upward revision in US Q1 GDP growth to 0.9% from 0.6% and the slightly stronger tone of data at the start of Q2 lessens the prospect of a technical recession.
Nichola James, Senior Economist, LTSB Corporate Markets

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

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