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Economics Weekly - BoE Inflation Report: King to have the last word, not Sentence;

Economics Weekly 9 August 2010


BoE Inflation Report: King to have the last word, not Sentance


Nine months into a cyclical recovery and the debate over UK monetary policy has become increasingly finely balanced. On the one hand, the pick-up in growth and the elevated level of inflation have strengthened the case for a preemptive rise in interest rates to start soon. On the other, the degree of uncertainty about the durability of the recovery and the potential disinflationary forces that could yet emerge have raised the possibility that more, not less, stimulus may be required. So which is it - should sterling markets brace themselves for an impending rise in interest rates; or should they be prepared for a renewed round of policy stimulus to stave off the risk of a double-dip recession?


The Bank of England’s Inflation Report, published on Wednesday, is likely to provide some important clues to this answer. Given recent developments, it is highly likely the Bank will revise up its short to medium-term inflation forecast. Since its last Report in May, CPI inflation, currently 3.2%, has remained stubbornly above the government’s 2% target. Looking ahead, the higher starting point for the CPI, coupled with the 2.5 percentage point rise in VAT in January 2011 raises the likelihood that inflation will remain higher for longer than the Bank previously anticipated (chart a).


But from a policy perspective, what matters most is not where inflation is likely to be over the next year or so, as there is little the MPC can do about altering the inflation outlook over the short-term. Instead, it is where the MPC expects inflation to be beyond two years, when the full impact of policy changes has been absorbed in the economy.  Therefore, the inflation forecast that will be most closely scrutinised on Wednesday will be the Bank’s projection at the end of its forecast horizon in three years’ time.


The Bank’s longer-term inflation forecast will be informed by its assessment of the future strength of the UK economy and what this may imply for the degree of spare capacity. This judgement in turn will be informed by trends in the money supply, the labour market, asset prices, and a host of other variables that are viewed as influencing the evolution of supply and demand, and the price, or inflation rate, at which these clear over the medium term.


So what are the recent indicators telling us about these variables? On the face of it, the economy appears to be doing relatively well. Having emerged from recession in Q4 2009, GDP growth has accelerated, rising by 1.1%q/q in Q2 – its strongest performance since Q1 2001. Other indicators are consistent with this improvement. The pace of unemployment, on both the claimant and ILO measures, have slowed noticeably; business investment has bounced back sharply; while the widely-watched PMI indices for services, manufacturing and construction are all back in expansionary territory.


It is the improvement in these indicators, and related concerns that the overshoot in annual CPI is starting to lead to some upward ‘inflation creep’ that has led to calls for a pre-emptive policy tightening. The most notable proponent of this view is MPC member Andrew Sentance who most likely voted for a rise in interest rates for the third consecutive month at last week’s policy meeting.


The rest of the committee, however, has yet to be persuaded of this view. Neither are we. To date, the recovery has been driven principally by a slower pace of de-stocking, a rise in government spending and, most recently, a substantial, but anomalous, rise in construction output. Construction output alone rose by a massive 6.6% in Q2, accounting for nearly half of the increase in GDP that quarter (See chart b).


Looking ahead, it is highly unlikely these sources of growth will maintain their recent momentum. The stock cycle is likely to start to slow noticeably in 2011, as inventories are brought closer into line with desired levels. The contribution from government spending will inevitably drop as fiscal policy is tightened. And growth in construction spending is likely to moderate, as the rise over the past quarter appears to have been temporarily, but significantly, been inflated by the poor weather in Q1 which delayed many construction projects. Construction output in Q2 may also have been boosted by the desire of some government departments to accelerate the start of public work projects before the publication of the autumn Spending Review.


Given recent developments, we expect UK growth over the second half of this year to be materially weaker. Our quarterly profile for GDP growth and the Bank of England’s latest projections (published in May) shown in chart c. Our own forecast is below the Bank’s previously published estimate in almost all quarters by some margin. Part of this difference reflects differences in the economic assumptions adopted and the models used. The impact of the measures announced in the emergency Budget, which factored into our projections, but not yet those of the Bank. Given the cuts in public spending and the rise in VAT next year, real GDP is likely to be  weaker than the Bank previously estimated. Given this, and the recent strength of sterling, we suspect there is a good chance that the Bank of England revises down its GDP forecasts, particularly for 2011, when it presents its revised economic projections this week.


Although an upward revision to its short-term inflation forecast may complicate the picture, it will be the Bank’s GDP profile, its longer term inflation forecast and the risks around these that are most important from a policy perspective. If, as we expect, the Bank concludes that the UK is unlikely to grow as strongly as it previously thought, we see little reason why the Bank’s longer-term assessment of the inflation outlook will be any less dovish than it published in May. Indeed, the collective judgement of the Committee could be that longer-term inflation prospects have weakened. With the Bank previously expecting CPI inflation to slightly undershoot the government 2% target at the end of its forecast horizon, any downward revision to its central forecast, or indeed the balance of risks, would likely be viewed as a strong signal that further monetary policy stimulus may be required over the coming months.


Adam Chester,

Head of UK Macroeconomics



Weekly economic data preview 9 August 2010


Markets await BoE Inflation report and FOMC decision



􀂄 As expected, the BoE’s MPC left Bank rate and the size of the QE program unchanged last week. This week sees the publication of the August Inflation Report which helped to underpin that decision. Relative to the forecasts presented in May, we expect to see a fairly substantial upward revision to the Bank’s outlook for inflation (party reflecting a higher starting point, but primarily the impact of the Jan 2011 VAT hike). However, revised prospects for economic growth will also weigh on the outlook. This, depending on the viewpoint, should provide both the hawk(s) and the doves on the MPC with added ammunition to argue their case more convincingly in the months ahead. Our own view is firmly in the dovish camp. We think that with the economic recovery far from assured and growth likely to slow in the second half of the year, the MPC may yet need to resort to further easing in monetary policy. As such, the press conference could end up focusing on how prepared the BoE is to implement further stimulus and what form it may take. In terms of hard economic data, the calendar is fairly light this week. Labour market statistics are expected to show modest growth in employment and a sharp moderation in average earnings growth – a rather toxic combination for household incomes. Also due out are external trade numbers for June.


􀂄 Friday’s disappointing payrolls report has added to the excitement and uncertainty around this week’s FOMC interest rate decision. Recent leaks, added to comments from Fed officials, indicate a decent chance that the FOMC could decide to take further measures to support the economy on Tuesday. The most likely change appears to be the reinvestment of cash received from maturing holdings of mortgage backed securities (MBS) into additional MBS or Treasuries, but other options are also available. On balance, we do not expect a change to policy at this meeting, as it appears too premature given signs that growth has sustained into the current quarter (both ISM surveys were above expectations in July and showed expansion), however we would not be surprised should it happen. Given this backdrop, the main data highlight this week is possibly July retail sales, where we expect to see the first gain for three months on Friday. The University of Michigan consumer sentiment index will also be closely watched to assess underlying conditions. Inflation data are also published on Friday.


􀂄 With so much bad news coming out of the euro-zone for much of this year, it was refreshing to hear ECB President Jean- Claude Trichet talk in more upbeat terms about prospects for economic activity in the region. Without question, this week’s key euro-zone data release is the “flash” estimate of Q2 GDP, where we look for an outturn of +0.6% quarter-on-quarter. Essentially, this reflects a strong net export performance in countries such as Germany compared with the position in Q1, where production was hampered by poor winter weather conditions. Our Q2 GDP growth forecast for Germany stands at 1.2% quarter-on-quarter, with other national data released during the course of the week. Italy has already published its Q2 figures, which yielded a 0.4% outturn.


􀂄 This week’s China data are set to provide further information on some of the key dynamics of the economy going forward. Following recent weakness in the Chinese PMI survey and disruptions to activity caused by flooding in the South of China, we expect industrial production to have moderated to 13.4% year on year. In line with a more moderate path of economic growth in H2, we forecast urban-fixed asset investment to have grown 26% in the first seven months of the year – significantly below the 32.9% increase in the same period in 2009. Also published this week, Chinese consumer prices are forecast to have risen 3.4% in July - above the government’s 3% target - as flood damaged crops have


Economic Research team


Lloyds TSB Corporate Markets Economic Research, 10 Gresham Street, London, EC2V 7AE, Switchboard: 0207 626 1500. Bloomberg: LLOY<GO>



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