Monday November 20, 2006 - 11:10:45 GMT
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Economics Weekly: Have UK interest rates peaked?
Economics Weekly: Have UK interest rates peaked?
Debate on next interest rate move not yet over
After the release of the November Bank of England Quarterly Inflation Report and the rise in base rates to 5% at the Monetary Policy Committee (MPC) meeting earlier in the month, the financial markets have lowered their bet that UK interest rates will rise in 2007. Other commentators have said that they believe that base rates have peaked at 5% and that the next move is downward. We think that this is a mistake, and with inflation still above target, money supply growth at a 16-year high, house price inflation accelerating and above trend economic growth, the Bank of England is more likely to raise interest rates one more time in this current cycle than not. However, it could be argued that the Inflation Report was more dovish than many had expected. Taking the market view of where UK base interest rates would settle in March 2007 prior to the Inflation Report and after its release shows that interest rates in the market are lower, see chart a. However, what is important to note is that this view of the likely direction of short term UK interest rates in 2007 still retains a bias toward base rates rising to 5.25%.
November Inflation Report more dovish?
The main part of the Inflation Report that caught the eye of many was that the MPC expects the inflation rate to get back to the 2% target six months earlier than in the August report and to be on or about the 2% target at the key 2- year period of the forecast, see chart b. This is interesting, since the latest Inflation Report also showed that economic growth is expected to be rather faster than in the August report as well. Reconciling faster economic growth with lower inflation in the new forecast implies that the MPC must believe that the UKâ€™s trend or potential rate of growth (the rate it can grow without generating inflation) is now higher. Indeed, the November Inflation Report alluded to this by remarking that the rise in immigration and lower inactivity rates have increased labour supply. The MPC continues to expect consumer spending growth to rise in line with its historical average rate of 2Â¾% a year, but now expects business investment growth to be stronger than reported in August. Net trade is also expected to provide a modest contribution to output growth in 2007.
Inflation in November appears to contain more uncertainty than in August
The central view is that consumer price inflation will rise further above target in the near-term, before falling and staying at the 2% target over the forecast horizon. Although the MPC still believes that the margin of spare capacity within businesses appears limited, they note that unemployment continues to rise and that pay growth has remained muted, implying that there is still some spare capacity available. But they highlighted a number of key risks to this central view; rapid growth in money and credit, the outlook for wages, energy and import prices and the extent of spare capacity that there is in the economy. Overall, however, they report that the balance of risks to economic growth and inflation seem evenly balanced.
Interest rates to rise to 5.25%?
The key point we take from the report about the central projection is that inflation only hits the 2% target because the market implied interest rate contains a further 1/4% hike. Without this increase, reflected in the alternative forecast of 5% interest rates being maintained over the forecast horizon, inflation remains above 2% and does not fall back to target in the forecast period, see chart b. For this reason, amongst others, we continue to look for a further 0.25% increase in base rates in 2007, most likely at the February meeting, when more data will have been released and another Inflation Report is due.
Signs of strengthening growth and inflation pressures
The other factors that we think are key to this view that base rates may rise further, are the continuing strength of the housing market and its close link to retail sales activity, see chart c. The latter implies that economic growth is likelyto remain above trend at a time when inflation is likely to remain above target. Chart d shows that our forecast is that consumer price inflation does indeed fall towards 2% in the middle of 2007, as the Bank of England expects, but then rises again in the second half of the year as economic growth remains robust. The other reason why we question whether inflation will fall back so quickly to target, and remain there, is the continued fast growth in money supply. As chart e shows, money supply growth and economic growth are closely linked, implying that growth should remain stronger than expected in 2007. This may put upward pressure on wage inflation, even though labour supply is rising. One reason for this is that the surge in immigration that forced a reduction in pay growth over the last 18 months is unlikely to be repeated to the same extent next year. This is the key to the Bank of England raising base rates to 5.25% next year, in our view. It means that interest rates will not be raised just because economic growth is strong, but will depend on whether pay inflation stays below 4.5% a year. The Bank will keep a close eye on this and on inflation expectations, which our monthly consumer survey shows is beginning to fall back, see chart f, but remain quite high and suggest interest rates may have to rise further. In this situation, if pay inflation accelerates and consumer inflation do not fall back to target, and stay there, then interest rates may yet rise above 5.25% in 2007. Our central view, though, is that base rates are raised to 5.25% early in 2007, and so increases beyond this will not be needed. But if the MPC does not raise rates in February, they are taking a risk and may have to raise them by more later in the year.
Commentary on economic data in the week
Few key economic data and Thanksgiving holiday in the US point to a relatively quiet week for financial markets ahead
â€¢ Financial markets may take the opportunity of a relatively quiet week for economic releases, especially in the US - Thanksgiving holiday - to take a breather and focus on more fundamental economic and technical issues in the market ahead of the final push to the end of 2006.
â€¢ However, economic news in the UK could again elicit strong market reaction, with the publication of the November MPC meeting minutes on Wednesday and the second estimate of Q3 gdp growth on Friday. Money supply figures, on Monday, may attract more attention than usual. Public finances data will be scrutinised ahead of the Pre-budget Report on 6 December.
â€¢ Recent economic data have led financial markets to trim expectations of a cut in US interest rates early in 2007. We think this is prudent. Comments from the Fed's Lacker (sole dissenter at the last FOMC meeting) on Tuesday should offer some clues about his current thinking.
â€¢ In the euro zone this week, the German IFO business survey, on Thursday, will attract most interest. The breakdown of gdp data for Q3 from France and Germany will also draw attention.
â€¢ BoJ October monetary policy meeting minutes may offer interest rate guidance on Tuesday.
We believe the mixed batch of economic data and less hawkish than expected Bank of England November Inflation Report last week has only temporarily clouded the outlook for UK interest rates and remain confident that the next move is likely to be up. The key point to take away from the Inflation Report was that based on interest rates staying at 5%, the BoE's central projection saw annual inflation remaining above target over the two-year horizon. Only by using prevailing financial market expectations, which showed interest rates above 5% throughout 2007 and most of 2008, did inflation fall back to its 2% target. The fact that this is now expected to happen sooner than forecast in the August Inflation Report is less important. Although annual CPI inflation surprisingly steadied at 2.4% in October, we, as also do the BoE, see it rising higher in the months ahead. In addition, we firmly believe that perhaps the most pertinent data released last week was October retail sales. This showed a sharp 0.9% increase, well above expectations and the strongest outturn since November 2005. The minutes of the November MPC meeting this week are likely to show a split vote on the decision to raise interest rates to 5%. This was further suggested by comments in the Inflation Report. However, if there proves more than one dissenter or, if the vote was unanimous, financial markets are likely to again re-assess expectations of rate hikes in 2007. National accounts data on Friday should confirm UK gdp growth was 0.7% in Q3, above its historic trend rate for a fourth successive quarter. There is a small risk of a downward revision. M4 money supply figures, on Monday, should show that the annual growth rate accelerated to 15%, a 16-year high. Also on Monday, BBA and CML lending data should show mortgage activity remained robust in October. This year's Pre-Budget Report will be published on 6 December and will ensure that the public finances data attracts more attention than usual on Monday. We look for a Â£2bn net repayment in October, taking fiscal year to date
borrowing to Â£23.4bn, compared to Â£20.9bn at this time last year.
Thanksgiving holiday in the US on Thursday promises a relatively quiet close to the week, but then nothing is certain in financial markets. US economic data are also very few this week and unlikely to be market moving. IHowever, comments from Fed member Lacker may elict some market reaction on Tuesday because of his hawkish stance. We remain of the view that US interest rates are likely to remain on hold at 5.25% in the near-term, with the risk of a possible hike to 5.5% in the first half of 2007, rather than a cut.
In the euro zone, the German IFO survey is likely to be the main market moving data this week. We expect a small rise in the business confidence index in November to 105.5, from 105.3 in October, on the back of lower oil prices and the rise in last week's ZEW current conditions index. The breakdown of Q3 gdp for France will be dissected to learn why growth surprisingly stagnated. German November inflation figures are due at the end of the week and are expected to show a rise in the annual rate to 1.4%, from 1.1% in October.
Trevor Williams, Chief Economist
Lloyds TSB Bank,
London EC3R 8BQ
0207 283 - 1000
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