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Monday September 25, 2006 - 20:00:08 GMT
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Economics Weekly: UK manufacturing shows best performance in 2 years

Economics Weekly: September 25, 2006

UK manufacturing shows best performance in 2 years

A funny thing happened last week, output expectations in manufacturing, as shown by the CBI survey, reached its highest level since December 2004. This means that UK economic growth is set to become more balanced than at any time since 2004. We examine the latest survey results from the CBI for the implications that they may have for economic growth in the year ahead and for monetary policy, concluding that a modest increase in interest rates is now more likely as growth strengthens and inflation pressure rises.

Industrial trends are improving…
There was a surprise rise in firms’ output orders in September, up from a balance of -8 in August to -5, which still means that there are more firms seeing declining orders than rising orders but the best performance since December 2004, see chart a. All of the results in the survey were positive, pointing to the widespread, and more likely sustained, nature of the improvement.

…helped by increased exports…
Perhaps surprisingly, exports are a key reason for the stronger results in the CBI survey of manufacturing. Results showed an improved export orders balance, with a rise to -3 from -6 in August. Of course the negative number suggests that UK manufacturers are still not fully benefiting from the surge in global trade, led by the emerging markets as a group but China, India, Brazil and Russia in particular. However, recovery in Europe is boosting UK exports. Overall, the survey showed that the balance of companies expecting to increase output in the next three months went further into positive territory, rising from a balance of plus 11 in August to plus 14 in September. Chart b shows this balance, if sustained, is consistent with a rise in official manufacturing output of around 2% a year, up from the current increase of 1% recorded in July.

There may be some concern about how long this can be sustained however, since the Purchasing Managers’ survey (PMI), which is also a good indicator of manufacturing activity, has shown some slippage from its 2006 peak in recent months. However, the survey is still suggesting that manufacturing output could be expanding by some 2% a year, in line with the results from the CBI survey.

An easing of firms’ cost pressures on the buying in, or input, side, stemming from a fall in oil and gas prices in the last month may have helped sentiment in UK manufacturing to improve. It may have also led to the fall in firms’ intention to increase their selling prices, see chart c, recorded in September. However, the chart also shows that price pressure is still strong, indicative of a continuing increase in price inflation of around 3½% for headline retail prices.

…but capacity pressure may increase…
Capacity pressure in manufacturing, resulting from the increase in output, may also be intensifying and could lead to price pressure. Chart d shows the lowest balance since 2004 for the number of companies reporting that they have spare capacity. This naturally implies less scope to keep prices down, that demand is stronger than it was and hence that output price increases might be more readily accepted. Certainly, 'demand uncertainty' as reported by the CBI is much less than it has been recently and that this is correlated with a rise in investment intentions, see chart e.

...putting upward pressure on inflation and interest rates
The policy implication of these figures is clear. Starting from the premise that economic growth ahead is expected to be sustained at about 0.7% to 0.9% each quarter by a recovery in manufacturing, as well as by a resurgence in consumer spending as the housing market recovers, it is clear that inflation may be under upward pressure from a lack of spare capacity. This could push up ‘core’ inflation, which excludes energy and foods, even at a time when headline price inflation may be falling as a result of lower oil and gas prices. This makes a rise in interest rates at the November MPC meeting very likely. Moreover, if the economy does record growth of around 2.8% for this year, as now seems likely, it will be starting 2007 with no output gap and so continued upward pressure on price inflation. Since this may be at a time that annual consumer price inflation on the targeted measure is rising at a rate well in excess of 2%, there could be another interest rate rise in 2007, taking base rates to 5.25%, a five year high.

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

Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.


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