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Economics Weekly - UK Economic Update: Downside risks argue for further stimulus; Weekly economic data preview - Like the US Federal Reserve, the MPC is positioning for a further bout of QE...

Economics Weekly - 18 October 2010

 

UK Economic Update: Downside risks argue for further stimulus

 

In this week’s commentary, we summarize our  latest UK economic forecasts, outlined in more detail in our recently published Q4 UK Economic Bulletin.

 

A fragile recovery

While we expect a recovery of sorts to continue, the challenges to growth remain formidable. Forthcoming public spending cuts - to be unveiled in more detail in Wednesday’s Spending Review - declining household disposable incomes and ongoing deleveraging will likely act as a major constraint on domestic demand growth next year.

 

As the government attempts to wean the UK off its reliance on public spending, a number of surveys - including our own - suggest GDP growth has softened noticeably since the summer (see chart a). Having posted a surprisingly robust 1.2% quarterly gain in Q2 – its strongest rise in a decade - quarterly GDP growth in both the third and fourth quarters is on track to slow to, or below, 0.5%. If realised, this would leave GDP growth for 2010 as a whole at around 1.6%. Although a marked improvement from the  4.9% contraction posted in 2009, this is well below the rates of growth that typically occur in the early stages of recovery.

 

Looking ahead, the typical recovery in stocks that accompanies economic recovery is likely to continue, but at a slower pace, as firms approach their desired inventory levels. Moreover, the consumer sector is likely to remain weighed down by stagnant income growth, high levels of debt, tight credit conditions and the looming prospect of renewed job losses. Lastly, the contribution to growth from the public sector looks set to weaken, as the government spending cutbacks start to bite.

 

This leaves business investment and net trade as important growth engines (see chart b). Companies’ growing financial surpluses, coupled with the historically low cost of credit, leave the corporate sector well placed to finance pent-up demand for business investment postponed during the downturn. Moreover, the recovery in global growth and the lagged impact of a weaker exchange rate should, with time, drive a more meaningful improvement in the UK’s net trade performance. More generally, loose monetary policy should provide ongoing support to the more interest rate sensitive sectors.

 

Overall, our central forecast is that GDP growth will continue to make modest headway – we expect GDP to grow by close to 2% in 2011. This is highly contingent, however, on the premise that cuts in public spending will promote private spending - and meaningful contributions from business investment and net trade.

 

We accept, however, that this is far from assured. Given the improvement in corporate balance sheets, there is little evidence that the public sector has been crowding out private sector investment. Despite the improvement in their balance sheets, it is questionable whether companies will embark on a substantial investment spend given the prevailing degree of spare capacity and the continued uncertainty over the economic outlook. Moreover, the recent volatility in sterling’s exchange rate, and signs that global growth may be starting to flag, could continue to delay an export-led recovery.

 

Inflation set to fall

In September, the annual CPI inflation rate was unchanged at 3.1%, the tenth consecutive month that headline inflation has been above the government’s 2% target (see chart c). Various reasons have been cited for its resilience. First and foremost has been the lagged impact of sterling’s exchange rate.

 

Although sterling’s trade-weighted exchange rate is currently around the same level as a year ago, it is around 25% lower than it was in mid 2007. Since the UK is a highly open economy - imports account for around 30% of GDP – the lagged fall in the pound has led to a sharp rise in import prices. Since mid 2007, import prices have risen by around 20%. We estimate this rise in import prices may have added up to 1.4pp to the rise in the CPI over the past year.

 

The reversal of the December 2008 2.5pp cut in VAT in January 2010 has also impacted on the rate of inflation. Retailers’ efforts to raise margins, and rising food and commodity prices, have also been factors. Over the short term, rising food prices are likely to continue to impact, while the 2.5pp rise in VAT in 2011 will serve to keep the headline rate of inflation relatively elevated through 2011. Nevertheless, inflation is expected to ease gradually over the coming year, before falling sharply in early 2012 as the January 2011 rise in VAT drops out of the annual comparison.

 

More generally, we believe the inflation outlook is benign. The overhang of spare capacity is likely to put steady downward pressure on domestic price inflation over the medium term, particularly given the outlook for wage growth and unit labour costs. Over the past year, average earnings (ex bonuses) have risen by only 1.6%, while the growth in unit labour costs has slowed towards zero. Furthermore, in the absence of an exchange rate shock, the impact of the earlier fall in the pound on import prices should steadily fade.

 

More QE?

Given our conviction that the recovery in UK GDP growth is likely to remain fragile and that inflation pressures are likely to dissipate, we have pushed out our forecast for the first rise in UK Bank rate until Q4 2011, with only a gradual tightening thereafter. By end 2012 and 2013, Bank rate is forecast to be 2.5% and 3.5%, respectively.

 

Indeed, market attention currently centres on the possibility that more, not less, monetary stimulus is required. If the forthcoming economic data confirm the downturn signalled in recent leading indicators, the Monetary Policy Committee (MPC) is likely to embark on a further round of Quantitative Easing (QE) in coming months. The scale and form any further QE takes remains uncertain, although our best guess is the Committee will increase the APF program by a further £50bn or so, with asset purchases again targeted mainly at the gilt market.

 

Adam Chester

Head of UK Macroeconomics

  

 

Weekly economic data preview - 18 October 2010

 

Like the US Federal Reserve, the MPC is positioning for a further bout of QE...

 

There are two events this week that have the capacity to significantly shift sentiment in the sterling interest rate and FX markets. Both are released on Wednesday. First are the minutes of October’s Monetary Policy Committee (MPC) meeting. Last month’s minutes provided a strong hint that at least one of the Committee felt the case for further policy stimulus was building. Since then, MPC member Adam Posen has put down a clear marker that the Bank of England may need to do more to prevent the risk of the UK entering a Japanese-style deflation. We expect the policy vote to reveal a three-way split, with Andrew Sentance again likely to have been the lone dissenter in favour of higher rates, but Adam Posen, and possibly one or two others, expected to have broken ranks in favour of further stimulus. Just as important as the vote will be the tone of the policy debate. With leading indicators pointing to slower growth, and the fiscal squeeze set to begin in earnest, we believe the minutes will take the market a step further towards pricing in more QE over the coming months.

 

The second key event this week will be the HM Treasury’s Spending Review. Although the total ‘spending envelope’ was laid out in the June Budget, the Spending Review will provide detail on where the axe will fall over the next four years. With spending on the NHS and overseas aid ring-fenced, other departments face real spending reductions averaging around 20%. The key questions for the markets are whether the Chancellor delivers on his tough rhetoric, and whether the planned cuts are credible. If this is the case, sterling bond markets will welcome the news. Apart from the Spending Review and the MPC minutes, the UK data calendar is busy this week, with CBI industrial trends and retail sales figures due.

 

In the euro-zone, this week’s focus is on forward-looking business surveys. Preliminary October euro-zone manufacturing and services PMI data are published on Thursday, where we look for a slower pace of growth in both sectors, to readings of 53.2 and 53.6, respectively. German and French PMI data are also released. From a national perspective, particular attention will centre on October’s German Ifo business climate index, due on Friday. As yet, there is no suggestion of a slowdown in key German export markets (e.g. emerging Asia), although we note that the expectations component has deteriorated for the past two months. We look for a softening in the overall business climate index to 106.2 from 106.8 previously. The ZEW survey is also due this week, where our forecast on economic sentiment stands at -10 .

 

There is little in the way of significant US economic data this week. The key exception is September housing starts (Tuesday), where we look for an outturn of 590k units versus 598k previously. Jobless claims are published as usual on Thursday.

 

Consistent with monthly indicators, we expect Chinese GDP growth to have eased to 9.5% year-on-year in Q3, down from 10.3% in Q2. While the Q3 result is backward-looking, September’s industrial production and urban fixed investment data, also out this week, will provide insight as to the extent of the moderation in the economy leading into Q4. We look for both to be broadly unchanged from August at 14% and 25% respectively. Meanwhile, Chinese consumer prices are expected to have accelerated in September, increasing 3.6% year-on-year versus 3.5% in August – comfortably above the 3% annual target. Elsewhere, we expect the central banks of Brazil and Canada to keep their benchmark rates on hold this week. However, we do not believe that this is the beginning of an extended pause in either country’s tightening cycle.

 

Economic Research team

 

 

 

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

 

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