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Monday July 4, 2005 - 10:12:10 GMT
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UK economic data revision make interest rate cuts likely

Economics Weekly: Economic Research and Analysis

UK economic data revision make interest rate cuts likely

Data revisions make interest rate cuts likely
Revisions to the UK economy going back 8 years show that it is bigger in cash terms than earlier estimated. However, the revisions also show that growth has been significantly weaker in the last three quarters than previously thought. Growth in Q1 2005 is now put at just 0.4%, down from the first estimate of 0.6%. This increases the chances of a cut in interest rates by the Monetary Policy Committee (MPC) this year, perhaps starting at this week’s July meeting. These figures, which are likely to have been seen early by the MPC, may have been what prompted the surprise decision of Charles Bean, the chief economist at the Bank of England, to vote for a rate cut at the June MPC meeting. If so, do these data revision now make a rate cut a done deal?

Forecasts have to change...
Estimates of economic growth in 2002, 2003 and the first quarter of 2004 have been raised, but growth in the rest of 2004 and first quarter 2005 have been lowered, see chart A. This has altered the pattern of growth while leaving the economy £1bn bigger than previously estimated in cash terms and £10bn in terms of constant 2002 prices. The facts show that growth in 2003 is now put at 2.5% rather than 2.2% and growth in 2004 is now estimated at 3.2% rather than 3.1%. The Treasury forecast of 3 to 3.5% UK economic growth for 2005 will have to be trimmed back significantly - the equivalent range would be 2.5% to 3%. Bur even this is no longer achievable with just 2.1% annual growth in Q1. Our forecast of 2.6% for 2005 now translates arithmetically into 2.1% based on the new data.

Pattern of economic growth has been altered
In terms of sectors of the economy, services output has been revised lower over the past year, manufacturing output has been much less changed. In terms of expenditure, consumer spending has been revised down, and grew by just 0.1% in Q1 rather than the earlier estimate of 0.3%. But chart B shows that consumer spending has been revised up overall, and even with the Q1 revision to just 0.1% growth it was still 2.6% higher than in Q1 2004 rather than the earlier estimate of 2%. The corollary of this has been that the household saving ratio has been revised lower, see chart C, as real income growth has been revised lower as well. However, real income growth was strong at 1.2% in the first quarter of this year, meaning that saving rates rose strongly in that quarter as people decided to spend less. But the household savings rate was revised down from 5.6% to average 4.2% in 2004, the lowest in 40 years. Does the MPC want people to save so little of their income, which is what an interest rate cut now would so imply? Moreover, with bankruptcies rising a cut in rates might be a two-edged instrument, helping some people meet interest payments on debt but encouraging others to borrow even more. Business investment spending has also been revised lower, see chart D, to 3.4% in 2004 from 5.5% previously. In Q1, it is now estimated to have risen by 0.1% rather than fallen, but the annual rate was put at 2.5%
rather than the earlier 2.9%. This makes it harder to see this sector growing by enough this year to compensate for the slowdown in consumer spending, though profits and liquidity suggest that it could. Government spending remains robust, up 0.7% in Q1, but it too has been revised lower, to 1.5% up on the year before rather than 3.4%.

Economy has less spare capacity now so...
The fact that growth has been weaker than thought recently means that it is now much more likely that there will be a cut in interest rates. This poses a problem for the MPC because although weaker growth suggests lower interest rates, a bigger economy suggests that there is less spare capacity, so less ability to grow without accelerating inflation. Our estimate of the output gap (actual output in sterling terms relative to potential expressed as a percentage) based on the latest data, depicted in chart E, shows that the economy has indeed got a positive output gap, though it is getting smaller due to below trend growth in the last few quarters. This means that inflation may still remain around 2% in the Bank of England’s inflation profile, which suggests that the MPC may rather wait until August too see the report than cut in July.

... interest rate cuts need not be aggressive
However, the real surprise in the chart is shown by the fact that the link with inflation since the 1960s seems
to have broken down in the late 1990s. No longer, it seems, does above trend growth, or a positive output gap, automatically lead to higher price inflation. This may make it even easier to justify a rate cut, but the instinct of the central bank might be a reluctance to cut rates when the economy has a positive output gap. Going forward, however, matters too and it is clear that UK economic growth in 2005 will be much less than earlier estimates based on these revisions, by up to ½%. That implies interest rates over 12-months could also be ½% lower. We have remained cautious, given signs that the housing market is recovering and price inflation could go above 2%, but have now changed our interest rate forecast from a hold to a cut of ¼%,
most likely at the August meeting. A further cut in 2006 is possible depending on how the economy performs. The MPC has been successful in slowing the economy with the increases in interest rates since the low in 2003, is it now time to reverse some of that but not too much so as not to encourage too much household debt accumulation?

UK economic indicators
Data this week in the UK will show that slow growth in M0 is in line with slow retail sales activity. The services PMI, on Tuesday, is likely to rise, reflecting better conditions in the financial markets. But industrial production on Wednesday should a fall for May, in line with the weaker PMI that month. Interest rates are likely to stay on hold in July even though the data revisions have raised the odds – the August meeting seems more likely to see a cut in rates because the Inflation Report will be available to the MPC though not yet published. House price data due in the week may show a small rise, if it follows the recent pattern of down one month up the next.

Trevor Williams, Chief Economist
[email protected]
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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