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Economics Weekly - Scenarios highlight risk of UK; recession; Weekly economic data preview - ECB set to raise interest rates; US June employment report due

Economics Weekly 30 June 2008

Scenarios highlight risk of UK recession

Credit crunch taking second place to worries about inflation...
With the credit crunch now taking second place to worries about inflation, interest rate futures are pointing to significantly higher official UK interest rates in the next two years. This is a sharp turnaround from a few months ago when they were looking for deep cuts. But the rise in consumer price inflation to 3.3% in May and the prospect that it will peak at well over 4% this year has led to a sharp change in sentiment in the financial markets. Moreover, UK consumers seem immune to the pressure from rising inflation, higher mortgage borrowing costs, falling house prices and lower confidence. Retail spending refuses to fall, rising by 3.5% in May to stand 8.1% higher in volume terms than in the year before. Our view is that employment growth is the key to this and as some people give up on owning a home, or moving near term, and spend instead, leading to lower savings and strong growth in sales.

...this could lead to higher interest rates...
With inflation rising, there is a clear risk that the MPC may be forced to raise official interest rates significantly higher, despite weaker overall growth. Because of this, we have calculated two scenarios, one where interest rates move in line with financial market expectations, as suggested by forward sterling interest rates, and a second where Bank rate is 2% higher than in our base case. The base case assumes only one increase in UK official interest rates, in early 2009 when the effects of the credit market crisis are fading and the implications of higher consumer price inflation for the economy are clearer. The results of this exercise are shown in the following charts. And the outcomes are clear: the Bank of England must be careful not to raise interest rates too much too soon. Such an outcome could make the unfolding economic slowdown too excessive, and lead to consumer price inflation undershooting the official 2% target in 2010. At the same time, our analysis shows that some increase in official interest rates seems necessary for inflation to hit the 2% target. But for that to happen, a period of below trend growth (2.3-2.6%) this year and next is inevitable.

...but our scenarios show that excessive rate hikes could lead to recession and inflation undershooting the target in 2010...
UK economic growth would slow to just 0.8% in 2009 if base rates were raised to 5.75% by September of this year. If base rates are raised by 200 basis points, i.e. to 7%, the UK would experience recession in 2009, see charts. That sets the limits for any rise in UK Bank rate, with anything above 1% likely to cause severe economic dislocation. This is in line with the analysis we did in 2007, which showed that UK Bank rate above 6.5% would lead to a contraction in economic output. One reason is that with UK households highly indebted a rise in base rates would raise repayment costs to such high levels that consumer spending would be cut back dramatically and consequently growth would fall back sharply, see charts. Another reason is that manufacturing output would also fall, leading to a decline in profits, lower investment spending and sharply lower employment. As this process takes hold, a vicious circle develops with further cuts in consumer spending as rising unemployment combines with significantly weaker earnings growth.

...so the MPC needs to tread very carefully in raising Bank rate
This latter position would be in sharp contrast to the present situation, where it is rising employment that seems to be one of the main bulwarks against recession, as it keeps total employment income rising, even as inflation erodes real spending power. Of course, if unemployment rose then house price falls and mortgage arrears would ratchet very sharply, alongside higher company default rates. But, as chart h shows, with Bank rate at 5.75% through to 2010, the inflation target would be sharply undershot. And if rates were raised by 2 percentage points to 7%, there would be falling prices. The MPC would be far too aware of this risk to allow it to happen, (Japan is a lesson to all) so one would realistically expect official rate cuts to be taking place as early as February of next year if they were indeed raised too high this year. This is one reason why we believe that rate rises this year, and especially to the extent that financial markets expect, are too excessive. A modest rise in rates, of perhaps 0.25% or 0.5% some time in early 2009 would be sufficient to bring consumer price inflation back to target in 2010. Moreover, our analysis also shows the futility of any attempt by the authorities in trying to get inflation back to the 2% target in 2009. All that happens is an excessive slowdown that actually does not even get inflation back to 2%, or below, in 2009. Inflation is set to fall back to target in 2010 - and to stop it from falling below target the MPC should not overdo rate rises this year. But the analysis also shows that Bank rate can only be cut from the current 5% if the economy is close to, or in, recession.
Trevor Williams
Chief Economist, Corporate Markets

Weekly economic data preview W/c 30 June 2008

 ECB set to raise interest rates; US June employment report due

 The ECB makes a point of never 'pre-committing' to changes in monetary policy, but considering last month's shift to a state of 'heightened alert' in the context of ever worsening inflation data and the further 10% rise in oil prices since then, we expect the central bank to lift the refi rate by 0.25% to 4.25% on Thursday. In the US, weak employment trends should temper any support for a rebound in June non-farm payrolls on Thursday and of an immediate rise in interest rates. PMI surveys of activity in manufacturing and services sectors top the economic calendar in the UK but may not do much to allay fears of a more abrupt economic slowdown and rising inflation as oil prices reach new highs.

• Financial market volatility last week and deteriorating forward-looking indicators of economic activity in the euro zone could be a reason for some ECB council members to oppose higher interest rates on Thursday. However, with no meeting scheduled in August and inflation set to accelerate to well over 4% in the summer, double the ECB target, we believe president Trichet will convince the council of the need to respond this week. Nominal interest rates in the euro zone have been too low in respect to the level of economic growth since last year and this carries some of the blame for why inflation has accelerated the way it has. Higher oil and food prices pushed CPI above 3.0% at the end of last year and are to a large extent responsible for the rise to a record high of 3.7% in May (preliminary figures for June are due this morning and may show a rise to 3.9%). Fears have escalated that a sharp rise in inflation expectations among households could lead employees to demand higher wages to compensate for the decline in purchasing power. The threat of a damaging inflation-wage spiral could destabilise the long term growth prospects of the economy and goes to the heart of why the ECB's mandate is centred on maintaining price stability over the medium term. With inflation only forecast to hit the 2% target in 2010, it is hard to see the ECB postponing a move this week. The grim inflation outlook means the pressure for tighter monetary policy is likely to remain acute in the 2nd half of the year, but does not imply that the ECB will embark on a series of rate increases.

• The Federal Reserve last week left interest rates on hold at 2.0%, but the threat of inflation led one member on the FOMC to vote for higher rates. Whilst monetary policy in the US is loose in relation to the level of nominal gdp growth, the case for an immediate rate hike is harder to justify at the present time and we believe that the Fed will probably leave interest rates on hold this year. The potential for stronger economic activity is tied to the speed of a recovery in housing and labour markets. With this in mind, we will concentrate on the June employment data due Thursday (US markets are closed on Friday for Independence Day). Weak labour market anecdotes last week, initial claims were unchanged at 384,000 and households were gloomier on actual and future employment prospects, suggest that the economy lost jobs for a 6th consecutive month in June. Our forecast is for a decline of 50,000. The manufacturing and non-manufacturing ISM surveys are also due this week and will offer some indication about the level of employment and activity in both sectors at the end of Q2.

• In the UK, the week starts with the release of mortgage lending data on Monday. Mortgage approvals have dropped to an all time low in Q2 and we expect demand for new household borrowing to have stayed at a low ebb in May, falling to £6.0bn from £6.4bn in April. Nationwide house prices are due on Tuesday and given the nature of the survey - it only considers approved mortgages - a fresh decline in prices is pencilled in for June. High oil prices are forecast to have taken a toll on business expectations in the manufacturing sector and this means that the sector PMI, due on Tuesday, may struggle to stay above 50 in June. The services PMI is due on Thursday and is forecast to show a rebound to 50.5, reversing some of the steep decline in May. However, the Bank of England's is currently more preoccupied with inflation and this implies that the output price components of the PMI's may be more instructive for the Bank's most likely course of action on base rate over the next few months. We still expect base rate to end the year at 5.0%.
Kenneth Broux, Economist

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