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Monday December 6, 2010 - 10:21:29 GMT
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ECONOMIC DATA ANALYSIS - MPC on hold, but inflation risks rising

ECONOMIC DATA ANALYSIS Monday, 6th December 2010


MPC on hold, but inflation risks rising


The recent run of reasonably upbeat UK data continued last week with the latest industry PMIs pointing to ongoing economic recovery. Indeed, if the manufacturing PMI is to be believed, business activity in this sector is currently running at its strongest pace since 1994. Services and construction activity are also holding up well. The improvements in these series and other activity surveys - including Q2 and Q3 GDP - have occurred against the backdrop of ongoing elevated inflation pressures. Consumer price inflation inched up to 3.2% in October. This is the 8th consecutive month inflation has been above 3%, and the 31st month out of the last 37 that it has been above the 2% target (the longest sustained overshoot since the MPC was formed in 1997).


It is against this backdrop that the MPC recovenes this week for its monthly policy discussion. As the November Inflation Report made clear, the upside risks to inflation have risen, with higher food and energy prices, and the upcoming rise in VAT, likely to keep inflation above 3% through early 2011. But for now at least, there remain good reasons for the Committee to look through some of these recent trends. The recovery to date has been from a very low base (suggesting there is still ample spare capacity) and is built on relatively fragile foundations - namely public spending, inventory rebuilding and low interest rates. None of these will last indefinitely, with the contributions from public spending and stocks likely to fade sharply through 2011 onwards.


Another worrying theme emerging in recent survey data is the persistent disconnect between fairly robust growth in output on the one hand and the weakness in employment growth on the other. In contrast to the headline readings, the employment components of the latest services and construction PMIs suggest employment in these sectors continues to contract. The so-called ‘jobless recovery’ is likely to be one of the key stories to watch next year, helping support the case for more, not less, monetary stimulus in the quarters ahead.


The fragile economic outlook, weak employment and wage growth, and ample spare capacity suggest it remains more likely than not that CPI inflation will fall below 2 per cent over the medium term. Indeed, given the extent of the economic downturn and the sharp fall in money growth (M4 has contracted 1% over the past year, its sharpest decline since records began in 1983), there is an equally persuasive argument that the UK could be headed for possible deflation. The upside and downside risks to the inflation outlook are neatly encapsulated in the Bank of England’s (BoE) November Inflation Report. As chart a shows, the BoE believes there is now less than a 30% probability that CPI inflation will fall within 0.5% of the 2% target over the medium term, with a material risk of an extreme inflation outcome.


The uncertainties clouding the inflation outlook have made the MPC’s job that much more difficult, with three distinct camps within the Committee having emerged. The arguments for increasing or reducing the degree of policy stimulus remain finely balanced and are likely to remain so for much of 2011. Given the uncertainty, theory suggests the optimal response is to maintain the status quo (akin to being in a pitch black room, your best chance of being found is to stand still). The MPC is almost certain to follow this maxim again this week, with both Bank Rate and the size of the QE programme expected to be left unchanged at 0.5% and £200bn, respectively. We still hold out the possibility, however, that more QE may be required next year to help offset weaker growth.


While the MPC meeting dominates this week’s calendar, there are a number of key economic releases also due. The highlights include the latest industrial production, external trade and produce price data. Following on from strong survey data recently, industrial production and manufacturing output (Tues) are both expected to post a decent rise in October. A fourth consecutive 0.3% monthly rise would leave industrial output close to 4% higher compared to a year ago – an impressive rate of growth certainly, but one that would still leave output in the sector some 10% below the level of output in 2008.


A rise in industrial production could set the stage for a narrowing in the visible trade deficit (Thurs), building on the past quarter’s momentum when export volumes rose by over 2%. The external trade data will be watched closely for further signs of rebalancing. Meanwhile, producer price data are expected to highlight the ongoing pressure on manufacturers’ margins, with input prices forecast to have posted another sharp rise, but output prices expected to be broadly stable. Other data this week include the CBI industrial trends survey, the NIESR’s latest GDP estimate and Halifax house price data. The DMO is also due to auction a £2bn long gilt (Tues).


Away from the UK, market attention is likely to remain focused on the high degree of volatility in eurozone government bond markets. Given the problems across the region, it is helpful that the German economy is performing well. Forward-looking business surveys (e.g. from purchasing managers and the Ifo) suggest the German economy enjoys considerable momentum at present. And this momentum is broad-based. There are, for example, signs of a revival in domestic demand – particularly consumer spending - as unemployment continues to fall. Meanwhile, Germany’s traditionally strong areas of production and exports are also robust. Tuesday’s German factory orders data for October (along with industrial production figures published the following day) will be closely watched for signs of a bounce after September’s 4.0% m/m decline. Our forecast stands at +3.0% m/m, fuelled by a strong improvement in export growth.


However, the medium term outlook for Germany is less certain, as the effects of an €80bn fiscal tightening package are felt over the next few years. So the current period of healthy growth in Germany presents a window of opportunity for the wider eurozone to address its difficulties. For now, the ECB continues to employ its (sterilised) bond purchase scheme to good effect. Irish and Portuguese government bond spreads have narrowed since last week’s ECB press conference. But this is not a long-term solution. We feel that weak confidence in eurozone government bond markets cannot be tackled through individual sovereign bailouts. And with markets demanding decisive fiscal action, it is this sovereign dimension which is causing problems of ‘contagion’. A package of measures designed to move the eurozone closer to a system of internal fiscal transfers seem desirable.


The US economic outlook seems relatively less complicated, although complacency is ill-advised at present. Just as fiscal consolidation is a crucial theme in the euro area, so it is in the US, where the political debate over whether or not to extent the Bush-era tax cuts (which expire at the end of this year), continues apace. Meanwhile, the US economic recovery is clearly occurring at a slower pace that the Federal Reserve would like to see. This week’s data are poised to shed a little more light on prospects for US activity going forward. Scheduled releases include October trade data and December’s preliminary University of Michigan consumer confidence survey, both scheduled for Friday.


The central banks of Australia and Canada meet this week. Recent softening in the economic data means official rates are likely to be kept on hold at 4.75% and 1%, respectively. Although markets have pared back expectations of the timing of the next rate rises, we expect increases in both benchmark rates in early Q2 next year.


Finally, Chinese trade figures will also be watched closely this week. Following a surprise widening last month, we expect China’s trade surplus to narrow to $22.3bn in November. But this is unlikely to ease pressure on the Chinese authorities to accelerate the pace of renminbi appreciation. Recently, Fed Chairman Bernanke and President Obama took issue with ‘large, systematically important countries with persistent current account surpluses’. While we believe that renminbi appreciation will be firmly aligned with the performance of the domestic economy, the recent surge in Chinese inflation suggests that the authorities may actually welcome a stronger currency to combat price pressures.





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