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Economics Weekly: UK inflation risks shift decisively upward

UK interest rate clues from financial market trends
In the last few months, UK yield curves have disinverted – that is to say they are no longer downward sloping – and are now upward sloping, see chart a. This suggest that instead of financial markets looking for weaker growth, weaker inflation and falling interest rates, they are now looking for faster growth, higher inflation and so higher interest rates. Part of the reason for this change of view was found in the May Bank of England Quarterly Inflation Report (BEQIR) and in the language used in the minutes of the MPC meeting the same month. We look at the UK central bank’s perception of one key driver of inflation looking ahead – the output gap.

Economic activity is strengthening
It is true that a range of UK economic indicators - retail sales, industrial production, the housing market and surveys of economic activity - have improved in recent months. But consumers are highly indebted and unemployment continue to rise, so it is not clear that UK interest rates need to rise quickly or aggressively, yet financial market sentiment has shifted decisively towards tightening, as shown in chart a. Indeed, at the May MPC meeting David Walton, who voted for a rate cut last August, has now changed his mind and voted for a rate rise. Chart b supports the change of view on the committee, although one member, Nickell, voted for a rate cut and the others voted to keep them on hold (a three way split last seen in August 1998). Economic growth, based on quarterly gdp growth assumed to persist for a year (annualised), shows that the economy has been recovering steadily since Q1 2005.

The minutes of the UK Monetary policy meeting in May were highly instructive in highlighting why Walton’s change of mind occurred. The MPC regularly discusses the ‘output gap’ – the difference between actual output growth in the economy and potential output growth - in the UK. In January, the minutes said there was ‘ample spare capacity’; in March, this had become ‘some’; in May, it was ‘just a little’. In other words, the MPC believes that the strengthening path of economic activity highlighted in chart b has left the economy with little ability to meet domestic demand without raising inflation should it grow faster than its long run average rate for any significant length of time.

What are ‘output gaps’ telling us about the next move in UK interest rates?
Why do ‘output gaps’ matter? Chart c shows that when the economy has a positive output gap (current growth is faster than the long run average with no spare capacity left), price inflation tends to rise quite sharply but when the economy has a negative output gap, price inflation tends to fall. Thus a view that the UK has a positive output gap may be why in the May BEQIR, the Bank’s forecasts show that if interest rates stay at 4.5% price inflation will be above the 2% target for the entire period of its projection. Moreover, even if interest are raised by the ¼% the markets were predicting at the time of the report, inflation still rises above the 2% target for some time before falling back to it.

UK base interest rates are likely to rise this year...
This forecast is clearly suggesting that official interest rates are likely to rise at some stage this year if this view persists. However, there are a number of different ways of calculating the output gap and the Treasury method, the green line in chart c, shows that the negative gap is a little over 1% of gdp. This would imply that the economy can grow for about a year or so above its run trend of 2½% before the negative output gap is closed. But two other methods (one based on average gdp growth over 40 years versus actual growth in each year and the other fitting a trend line through the data), also shown in chart c, suggest that the output gap is closing quickly. These support the Bank’s view that there is ‘little’ output gap left, suggesting scope for higher base rates even if energy prices unwind, especially if the economy is expanding at a greater pace than 0.6% a quarter, or 2.4% a year. The Bank’s forecast of some 2.6% annual economic growth this year and about 2.8% in 2007 therefore implies that it will raise interest rate sometime during this period. The lags shown in chart C for a closing output gap to impact on inflation suggest that a rate hike will take place this year.

..but the Bank can wait for some months before acting, though the bias is now to tighten
The fact that wage inflation is still below 4.5% a year and unemployment is rising suggests that the MPC will wait for some months yet before acting, but the odds of a rate rise this year have shortened. Chart d seems to confirm that this is also the current financial market view, a significant change from the view a few months ago.

Trevor Williams, Chief Economist
[email protected]
www.lloydstsbfinancialmarkets.com
Lloyds TSB Bank,
Financial Markets
Division,
Faryners House,
25 Monument,
London EC3R 8BQ
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