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Economics Weekly - How real is the inflation threat? Weekly economic data preview - Fed and BoE to quash speculation of early rate hikes

 Economics Weekly - 22 June 2009

How real is the inflation threat?


Recent developments have raised concerns that the UK could be facing an upsurge in price inflation over the coming years. Since early March, oil prices have doubled; the economy has found a firmer footing; and broad measures of inflation expectations have shifted higher. The rise in some of the forward-looking inflation indicators has occurred as the Bank of England has embarked on an unprecedented loosening in UK monetary policy. Having cut interest rates to a record low, the Bank has turned to the unorthodox policy of quantitative easing (QE) in an effort to stimulate lending and demand through expanding money supply.


Inflation expectations have turned upwards

The concern about future potential inflation has started to unsettle bond markets. Medium and long-dated gilt yields have backed up sharply since early March (see chart a). Part of this upward adjustment reflects rising concerns over the current and prospective level of public sector debt issuance. Part of it reflects rising real interest rates and a more general reassessment of risk premia as equity markets have improved. But the rise also reflects a noticeable shift higher in the market’s perception of inflation risk.


Since the Bank unveiled its quantitative easing programme in early March, long-dated breakeven inflation rates have risen by around 1 percentage point, to 3.7%. RPI inflation swaps tell a similar story. Since last November, the annual RPI two years forward has risen from less than 1% to 3% (see chart b). Adjusting for differences in methodology and definition, the increase in inflation expectations suggests financial markets doubt the ability of the Monetary Policy Committee (MPC) to meet the government’s 2% inflation target over the medium term. But it is not just the markets that have started to exhibit some scepticism. The latest Bank of England/NOP Inflation Attitudes Survey shows that the public’s perception of the inflation outlook over the next twelve months picked up slightly in May, to 2.4% from 2.1% in February, despite slower actual inflation ( see chart c).

But medium-term inflation concerns are overdone

While there may be justifiable concerns about the inflation outlook over the longer term, the creeping pessimism about the medium-term prospects looks misplaced. With the economy still in recession and unemployment continuing to rise sharply, the current economic environment is more consistent with deflationary, rather than inflationary conditions. Although ‘green shoots’ have started to emerge, the prevailing level of space capacity indicates that businesses are operating well below potential – hardly a recipe for a significant demand or supply induced rise in prices. We estimate that the UK is currently operating with a negative output gap of around 6% - i.e. the level of actual output is about 6% below the level that could potentially be produced given the current pool of available labour, labour productivity and capital stock (see chart d). Not surprisingly, inflation and the output gap are reasonably closely correlated. As demand weakens, unemployment tends to rise, putting downward pressure on wage and, with a lag, consumer price inflation.


Indeed, this describes what has occurred over the past year or so. Since February 2008, claimant count

unemployment has risen by 760,000 and underlying average earnings growth has slowed from 3.7% to 2.7% (see chart e); since last September, consumer price inflation has dropped from 5.2% to 2.2%. With

unemployment almost certain to continue rising over the remainder of this year and into 2010, we expect CPI inflation to fall further – to below 1% by the end of this year, (see chart f). Over the coming months, the fall in inflation also is likely to be accentuated by favourable base effects, as last summer’s sharp rise in food and energy prices drop out of the annual comparison. Although unemployment is still expected to be increasing for much of next year, headline inflation is expected to gravitate slightly higher, as the temporary cut in VAT expires in January and demand conditions gradually improve.


Even if GDP bounces strongly, the output gap will remain negative for some time..

Nonetheless, it is difficult to make a strong case for a fundamental shift higher in inflation until the output gap closes. Such an outcome requires a sustained period of above-trend growth. While recent indicators suggest the inventory adjustment may now be largely complete, this points to a stabilisation in output, not necessarily a resumption of growth. Moreover, even if the economy were to exhibit a sharp rebound, it would take time for the level of spare capacity to erode to the point where inflation pressures started to build again. Broadly speaking, for the current output gap to close, GDP would have to rise by 2% above trend over the next three years. While low interest rates and quantitative easing may pose longer term risks, the degree of spare capacity poses a formidable obstacle to a pick-up in inflation in the short term.


...trend growth may have fallen, but not by enough to induce price pressures

Admittedly, there is a caveat to this. Estimates of the output gap are almost impossible to derive with precision as the growth potential of the economy changes over time in response to changes in the capital stock, productivity, and the available pool of labour. Since the credit crisis erupted, the capital stock has clearly been depleted as a result of the decline in business investment and rising corporate bankruptcies. This represents a permanent loss of output. Moreover, reports suggest that migrant workers are increasingly leaving the country. Proponents of rising inflation argue that these developments leave the UK more exposed to inflation pressures when demand picks up. While this may be true over the longer term, we believe it is highly implausible that the UK’s trend rate of growth has fallen to such a degree that the UK is exposed to supply-side price pressures. Although the capital stock has been depleted, the proportion of the UK population that is economically active has actually risen slightly, as the downturn has obliged some individuals to re-enter the labour market.


Finally, demand conditions pose little threat to inflation

Moreover, from a demand perspective, there appears little threat of inflation. Unemployment continues to rise sharply, credit availability remains constrained and household indebtedness is close to a record high. None of these seem consistent with an imminent improvement in corporate pricing power. Inflation looks set to stay low for a while longer. Consequently, fears of an early rise in interest rates seem premature.



Weekly economic data preview -22 June 2009


Fed and BoE to quash speculation of early rate hikes

The improvement in economic activity data in recent weeks has raised market speculation about the potential ‘exit strategies’ central banks may employ from the various initiatives undertaken to tackle the financial crisis. However, with considerable uncertainty still overshadowing prospects for future economic growth and inflation, we believe such considerations may be premature at this time. We expect both the Fed and the BoE to communicate messages along these lines this week. The FOMC will be armed with updated economic forecasts which, though likely to show an improvement in underlying economic conditions, may also predict that economic growth could remain weak for some time, increasing spare capacity and reducing the medium-term threat posed by inflation. We expect the committee on Wednesday to maintain the target range for the federal funds rate at 0-0.25% and to keep its total purchases of Treasury securities unchanged at $300bn on Wednesday. Members of the BoE MPC testify to a Treasury select committee on the May Inflation Report on Wednesday. We expect the main message here to be that with recovery still not assured, Bank rate will remain at 0.5% for some time, while additional quantitative easing also cannot be excluded. It is another big week for government bond issuance, with the US Treasury auctioning a record $104bn. Euro zone PMIs, the German IFO survey, final US Q1 GDP and US personal income and spending for May provide the main data highlights this week.


􀂄 It is a very quiet week for data in the UK, with the CBI distributive trades’ survey on Wednesday and BBA lending figures on Tuesday potentially the only releases of market interest. We expect the CBI headline reported sales index to show a further decline to -20 in June, from -17 last month, as rising unemployment and tight credit conditions increasingly weigh on retail spending. We forecast BBA mortgage approvals rose above 30,000 in May, from 27,685 in April, equating to year-on-year growth for the first time since November 2006. However, the number of loans approved for house purchase in November 2006 was 79,981, highlighting how subdued market activity actually remains. The Nationwide house price survey may also be published this week. However, the main focus in the UK this week will be on the BoE MPC testimony on Wednesday on the May Inflation Report , where we expect to hear more about the economic outlook, the progress of quantitative easing so far and how the timing and mechanics of an eventual exit strategy will be determined. Senior BoE members, including governor King, will also testify on the banking crisis later on Wednesday.


􀂄 Although we expect to hear that the overall policy stance will remain unchanged following the FOMC meeting on Wednesday, the press statement will be closely scrutinised for any clues about future direction. We look for the FOMC to dampen recent market speculation of an early interest rate rise, primarily by highlighting the high degree of uncertainty and risk still surrounding prospects for inflation and economic growth. The need potentially for increased purchases of treasury securities may also feature in the press statement, although the current $300bn remit is unlikely to be changed at this time. The Fed is already more than half way through its current programme, which it expects to complete by Autumn. US data this week are likely to support the view that the economy will return to modest growth in coming quarters. We look for a solid rebound in personal spending in May, underpinned by the boost to incomes provided by the recent stimulus plan. There is a chance that initial jobless claims dipped below the 600k level in the week to June 20 for the first time since January, a further indication that labour market trends are improving. We also forecast modest increases in new and existing home sales for the second consecutive month in May, as lower prices spur renewed activity. Confirmation that the economy contracted by an annualised 5.7% in Q1 2009 is unlikely to elicit much market reaction on Thursday.


􀂄 Data in the euro zone this week are also expected to show that the worst of the downturn may have passed, although prospects for recovery there may not be as strong as in the US or UK. We look for further rises in both the manufacturing and services PMIs, to 42.5 and 46 respectively, though crucially still deep in contractionary territory. The German IFO survey is also forecast to show a third consecutive rise in its business climate index, to 85.5 in June, but this is still consistent with weak output growth.

Jeavon Lolay, Senior global macroeconomist


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


Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.



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