Economics Weekly - UK Inflation Report implies no rate hike this year; Weekly economic data preview - Governor King to play down inflation threat
Economics Weekly - 15 February 2010
UK Inflation Report implies no rate
hike this year
The Bank of England‚Äôs projections in the February 2010
Quarterly Inflation Report (QIR) for economic growth (GDP) and for consumer price
inflation (CPI) are lower than those made in November last year. This has
resulted in financial market expectations of rate rises being pushed out
further into the second half of this year. But, as the charts below show, there
is still an expectation - derived from overnight index swap (OIS) rates - that
Bank Rate will rise to 1% by the end of 2010, to 1¬ĺ% in June 2011 and to 2¬Ĺ% at
the end of next year. That view is not borne out by the implied path of
consumer price inflation in the Bank of England‚Äôs latest QIR forecasts, whether
based on market implied interest rates or unchanged rates at 0.5%, see charts a
and b. In the Report, the Bank says that: ‚ÄėOn balance, the Committee judges that‚Ä¶..
it is more likely than not that inflation will be below the target for much of
the forecast period‚Ä¶‚Äô The implication is clear, there is a strong probability
that Bank Rate may remain at the current record low of 0.5% well into 2011 unless
economic conditions improve more than currently expected by the Monetary Policy
Reasons for the Bank of England to lower
its growth forecasts are not hard to find. The UK economy expanded by just 0.1% in Q4.
This means that there is more spare capacity in the economy and so medium-term
inflationary pressure is even more muted than previously expected. Prospects
for growth in the first half of this year look very challenging, with the
reimposition of VAT at 17¬Ĺ%, the end of the car scrappage scheme and higher
taxes from April.
World growth is recovering and that
helps UK growth prospects, but the evidence so far is that the trade balance is
not improving as much as is required to impart the positive net contribution to
the economy that would deliver the Bank of England QIR projection of 3% annual
GDP growth by the end of the year, see chart c. Part,of the reason for that
could be that the fast growing countries are those in which the UK has a low
market share of imports, and that UK firms are not cutting export prices in
order to gain market share; rather, they are maintaining them (i.e. raising
export prices) in order to boost profit margins.
The view from the latest Consensus
Forecast publication (for February) is that the UK will grow by 1.4% this year and by 2.2%
in 2011. Of course, the QIR forecast could turn out to be correct, but that
would still mean that inflation undershoots the 2% target in 2 years‚Äô time on
official projections, see chart b.
Although inflation is expected to
undershoot the 2% target in the medium term, however, the
Committee expects the annual rate to
rise over 3% first (the annual rate was 2.9% in December
2009). Our forecast is that this will
happen as soon as this month, with January annual CPI inflation hitting 3.5%
and triggering a public letter by the Governor explaining to the Chancellor why
it has happened, what he is doing about it and when it will be back to the
target. In that letter, the Governor is likely to say that the rise was due to
one-off effects associated with the 2¬Ĺ% rise in VAT and petrol prices, and that
it will be well below 2% within the target period of 2 years.
In the QIR, the Bank states that: ‚ÄėThe
pick up in inflation is largely the impact of one-off adjustments to the level
of prices which should have only a temporary effect on inflation. Downward
pressure from the persistent margin of spare capacity is likely to cause
inflation to fall back below the target for a period as these temporary effects
wane‚Ä¶.it is more likely than not that inflation will be below the target for much
of the forecast period, but the risks are broadly balanced by the end.‚Äô Our
forecasts of the monthly path of annual UK consumer price inflation over the
period to the end of 2011 show that it will fall well below 2%, hovering around
1% for much of 2011.
If our forecast turns out to be
accurate, the key short term UK policy interest rate could stay low for
an extended period, and much lower than is currently being priced into
financial market expectations. This will be especially likely if UK economic growth disappoints, as it has
so far in the recession. Bank of England forecasts of UK growth in 2010 and 2011 are higher than
the average of independent forecasters. If the latter are right, and the MPC
acknowledges this by lowering its inflation projections even further below 2%,
then UK Bank Rate could remain at 0.5% well into 2011.
From a financial market perspective,
this implies plenty of scope for market volatility, and perhaps opportunity as
a result, in the months ahead. As mentioned in our last Weekly, much of the
prospects for the UK depend on how firms adjust away from
slower growing traditional export
markets into stronger growing emerging
markets, helped by a cheaper currency.
ŰÄāĄ Following on from a dovish Quarterly Inflation Report (QIR), attention
in the UK will shift this week to the details of
the February MPC minutes (Wednesday). Although the tone of the minutes are
likely to echo key the messages emanating from the report ‚Äď chiefly, that
should the evolution of the recovery disappoint, a renewed dose of quantitative
easing will be implemented ‚Äď the vote will also be of interest. We expect a
three-way split to have emerged on the MPC, with three members favouring an
extension to the Asset Purchase Facility, a majority of five voting for
no-change and one voting for a reduction. Turning to UK data flow, we expect a 0.1% monthly
decline in the CPI for January (Tuesday), pushing the headline annual rate of
inflation up by six percentage points (pp), to 3.5%. A reading above 3% will
prompt a letter from Governor King to the Chancellor, explaining why inflation
is more than 1 pp above the 2% target and how the MPC envisages a moderation in
inflation occuring. We forecast a 2k decline in the January claimant count,
while the headline measure of average weekly earnings is expected to rise by
two-tenths to 0.9% in the three months to December, versus a year earlier.
Nonetheless, that would be a very weak outturn compared to the long-run average
of 3.8%. Indeed, weak income growth is likely to bear down on consumption and
in January, the combination of inclement weather and price rises linked to VAT
increase are likely to have pushed retail sales volumes (Friday) 1% down in the
ŰÄāĄ The main focus in the US will be the Fed‚Äôs ‚Äėexit strategy‚Äô and
the gradual normalisation of monetary policy. Following the testimony by Fed
chairman Bernanke last week on the potential methods the Fed may adopt to
withdraw the substantial monetary stimulus in place, attention will fall on a
host of other Fed speakers this week. The list includes Hoenig, the first dissenter
on the FOMC for twelve months in January. The minutes of the 26-27 January FOMC
meeting will also be published on Wednesday. However, it is a quiet start to
the week for data and events, with US financial markets also closed for the
Presidents‚Äô Day holiday on Monday. The central theme for data releases this
week will be inflation, with a succession of reports published. We look for
robust increases in import prices (Wednesday) and producer prices (Thursday),
primarily reflecting higher fuel & energy prices in January. The consumer
price index (Friday) is forecast to rise by 0.3%, lifting the annual rate
slightly to 2.8%, while the core rate is expected to be unchanged at 1.8% on
the year. We expect to see a rebound in January housing starts (Wednesday),
mainly reflecting more favourable weather conditions, while building permits
are likely to remain close to year-highs. After the larger-than-expected fall
in initial jobless claims data last week, another improvement on Thursday will
fuel speculation of a gain in non-farm payrolls in February. We also expect to
hear this week of another robust gain in industrial production in January
(Wednesday), while the Empire (Tuesday) and Philadelphia (Thursday) Fed surveys should point to
a further pick-up in activity in February.
ŰÄāĄ Weak public sector finances in the ‚Äėperipheral‚Äô euro-zone countries
has been the dominant theme in financial markets. For us, last week‚Äôs pledge
from the EU of ‚Äúdetermined and co-ordinated action if needed to safeguard
stability‚ÄĚ seems too vague to placate bond markets. A bailout does not sit
easily with the Maastricht Treaty - which states that financial assistance is
only available to a Member State seriously threatened by ‚Äė‚Ä¶exceptional
circumstances beyond its control‚Äô‚Äô. Greece does not obviously fall into this
category. A high degree of supervision, along with possible additional fiscal consolidation
measures, seems the likely way forward for Greece, although it may be too soon to rule
out some kind of non-EU financial assistance. This week‚Äôs euro-zone economic
data highlights include the February German ZEW survey and preliminary February
PMI reports. A ZEW economic sentiment reading of 40.0 is expected from 47.2 previously,
reflecting more volatile equity markets and the tentative return of risk
aversion. Meanwhile, we look for the PMI surveys to register a modesty faster
pace of expansion in both the manufacturing and services sectors.
Jeavon Lolay, (Senior Global
Macroeconomist, Mark Miller (Global Macroeconomist), George Johns (UK Macroeconomist)
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