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Financial markets bet on interest rate cuts in the U.K.

Economics Weekly: Economic Research and Analysis
27 June 2005


Financial markets bet on interest rate cuts in the U.K.

MPC minutes prompt rate cut speculation
Minutes of the June meeting of the UK Monetary Policy Committee (MPC) were released on Wednesday 22nd and immediately caused financial markets to look for a cut in UK interest rates. This followed on from rising speculation in Europe about a reduction in interest rates by the European Central Bank (ECB), which was given impetus by the decision of Sweden’s central bank, the Riksbank, to lower its interest rates by ½% to 1½%. The vote pattern on the MPC caused the big surprise, with a 7-2 decision to leave interest rates at 4.75%. The 2 dissenters voted for a 25bp cut in interest rates, arguing that a reduction now might obviate the need for bigger ones later on. But in March, just three months before, there was also a similar split on the MPC to leave interest rates at 4.75%, but in that instance the 2 dissenters wanted to raise interest rates by ¼% to 5%. What has changed since then?

Economic data changed for the worst
The first point is that economic data have generally taken a turn for the worse. Retail sales growth is weaker, industrial production fell in Q1, oil prices are higher and growth in Europe is showing signs of slumping back after recovery in 2004. The UK manufacturing PMI fell to 47.3 in May, from 49.1 in April, and has now been below 50 (signifying contraction) for two straight months. The CBI Industrial Trends survey also painted a challenging picture for the sector in May, with the index for total orders still weak and output volumes expectations turning negative for the first time since December. At the same time, wage inflation appears to have stabilised at a level the MPC is comfortable with and claimant count unemployment has risen in the last few months. ILO data, which is more internationally comparable, contradicted the claimant data and showed an 11,000 rise in the number of people in employment and a 15,000 fall in those unemployed in the quarter to April. The labour market therefore remains tight and should underpin a rebound in consumer spending later in the year. However, earnings data for April continued to suggest wage pressures remain restrained, with annual average earnings rising by 4.6% including bonuses and 4.1% excluding them.

…but is growth weak enough for rate cuts?
By itself data changes may not have been enough to lead to the intense speculation of rates cuts by September, shown in chart A, but importantly, however, the key dissenter wanting a cut in interest rate was Charles Bean, the Chief Economist of the Bank of England and a rare dissenter. He is charged with responsibility for producing the quarterly Inflation Report, which is crucial to the forecast of where inflation will be relative to the 2% target. Hence, the view is that August’s Inflation Report will show price inflation below target in two years time, so justifying a cut in interest rates. But the interest rate market may still be wrong in its guess of a cut in interest rates. For a start has the economy really changed that much in 3 months? Chart C shows that economic growth is still around trend on a quarterly basis, at 0.5% in Q1, and above trend on an annual basis at 2.7% higher than in the same period of 2004. Annual growth of 11.6% in M4, the broad measure of money supply, suggests that consumer spending and the housing market may be having the soft landing recent data for these variables suggest. Housing market indicators continue to imply the market is stabilising. As expected, annual house price growth is tailing off sharply but monthly price changes are flat, with rises in one month being offset by falls in the next. Growth of M4 is inconsistent with stable inflation, a point not missed by BoE Governor King. He has also suggested that imported inflation is a threat to inflation, partly due to higher oil prices and recent sterling weakness against the US dollar. Producer input prices rose by 0.3% in May, against market estimates for a sharp fall, and are now 7.8% up on the same period a year ago.

Inflation near target
Annual CPI inflation remained at 1.9% for a third month in May, against estimates of a slight fall, as wider price pressures offset the significant downward effect from lower oil prices in the month. Our latest monthly profile shows CPI inflation breaching the 2% target in coming months and remaining slightly above it until 2006. This suggests that a rate cut is not a done deal. In addition, the MPC is split. Marian Bell, who also voted to cut interest rates, has now left the MPC to be replaced by David Walton, who may vote with the majority. So, assuming Charles Bean does not change his mind, he may be the only member voting for a rate cut at the 6/7 July meeting. The majority seem prepared to wait and see if the economy weakens further over the next few months or if it recovers, removing the need to lower interest rates. Chart B suggests that the current level of rates is well within our measure of its 'neutral' range - i.e., in line with nominal growth in the economy. However, economic data have been weaker in the last 2 months and if the economy does not recover as we expect in the next few months, then a rate cut before the year end is likely. But October would look more likely than August, as time is required to assess the flow of data. However, the August meeting will be critical to financial market perceptions because it is accompanied by an Inflation Report. A solid core on the MPC remain worried about labour market tightness; where targeted inflation may be in a few months time and by the lack of spare capacity in the economy. They would rather wait to see whether consumer spending recovers later this year, and growth returns to an above trend pace, before acting. That may mean interest rates remain on hold all year.

MPC majority against cutUK economic indicators
UK credit data, on Wednesday, are expected to show overall household borrowing growth slowing in annual terms, but at around 10% is still twice the rate of income growth. We look for consumer credit in May to rise, to £1.7bn, and mortgage lending to edge up. Retailers’ expectations about their sales are dismal and this is unlikely to have changed in June. But there is a chance that gdp growth in Q1 could be revised up, due to stronger net trade. Consumer data within the total will be scrutinised for signs of how consumer demand is developing, as will confidence figures for June due on Thursday. Finally, PMI data for manufacturing may show that output trends remain weak.

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
Lloyds TSB Bank,
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