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Monday December 18, 2006 - 11:23:56 GMT
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Economics Weekly:Will UK labour market tightness lead to higher inflation? - Weekly economic data preview

Economics Weekly:

Will UK labour market tightness lead to higher inflation?

In recent publications and comments, some members of the Bank of England’s Monetary Policy Committee (MPC) have voiced concern about the implications for price inflation from labour market strength. These concerns must now be even greater in view of the recent labour market data for November, which showed that employment rose and unemployment fell. We look at what this may mean for monetary policy in this week’s article, concluding that the risk of an interest rate rise in early 2007 has increased.

In the last few months, claimant count unemployment has turned from a fall to a rise. Recent data showed the biggest fall since January 2005, 5,700, keeping the rate of unemployment at 3% (chart a) and implying, if these falls were to be sustained that the rate of unemployment will fall further. In fact, when measured by the labour force survey, a more widely accepted international method, the unemployment rate fell from 5.6% to 5.5% in the three months to October. On this basis, the UK labour market has tightened in recent months. The reason is that economic growth is picking up speed and employment has risen as economic growth has accelerated (chart b). Moreover, growth in money supply, see chart c, is fast enough to justify continued above trend growth in UK gdp, and the possibility of further acceleration next year.

The figures for November also showed that pay inflation is beginning to pick up. Earning growth rose to 4.1% in the three months to October, from 3.9%. Excluding bonuses, the rise was from 3.5% in September to 3.8%. These rates are still low, but with the current fast pace of economic growth, price pressure is likely to intensify. In 2006, earnings growth was kept down by net migration and lower inactivity rates, see charts d & e, but this is unlikely to remain at the same intensity in the year ahead. Earnings growth is still below the critical 4.5% threshold (based on 2% productivity growth and 2% real earnings growth), but is now accelerating. More importantly, as the chart shows, price inflation picked up in November. Core price inflation is now 1.6%, well above the five year average of 1.25% (chart f). The link between price inflation and wage inflation suggests that earnings will now be under upward pressure (chart g). It is very difficult to see why, with price inflation at these levels, wage inflation will not rise and add to the difficulty of getting price inflation back below 2% (on our forecast it remains above target during 2007, see chart h). This means that monetary policy in 2007 is set to tighten. The question is whether or not interest rates only rise a further 0.25% or whether the MPC leaves it too late and interest rates end up rising towards 5.5% or above.

Trevor Williams, Chief Economist

Weekly economic data preview

Bank of England MPC minutes could reveal a split vote

• The minutes of the Bank of England December MPC meeting could show that some members already voted for another rate increase to 5.25%. Economic data due this week includes house prices, public finances, final Q3 gdp and the current account.

• Housing market data lead the economic release calendar this week in the US. Q3 current account data, final Q3 gdp and inflation data are also due. Fed FOMC member Lacker, who last week voted for higher US interest rates, will present his views on the economy.

• In the euro zone, Germany will publish its latest IFO survey of business sentiment. ECB president Trichet will testify to the European Parliament where he may comment on inflation and offer some clues on the trajectory of interest rates next year.

• The Bank of Japan meets on interest rates. The Bank is forecast to leave rates on hold at 0.25% despite a stronger Q4 Tankan business survey last Friday.

UK economic data will be overshadowed by the release on Wednesday of the minutes of the Bank of England December MPC meeting. A sequence of strong data since the start of the month has strengthened the argument for higher UK base rates next year, resulting in a rise in 5yr swaps above 5.30% last Friday for the first time since October. However, the data on inflation, unemployment and retail sales were only released last week and are unlikely to have featured in the debate on interest rates earlier this month. Nevertheless, the discussion could still provide some interesting insights about thinking on the MPC. The Bank's assessment of the balance of risks vis-a-vis inflation and the shift upwards in implicit market interest rate expectations (see chart below) could provoke some interesting comments from the monetary policy committee. Divisions between those advocating higher interest rates vs those pleading for no change surfaced in November and comments from various committee members in the interim from Andrew Sentance, Rachel Lomax, Paul Tucker and John Gieve suggest the minutes may again show a split vote. The latest RICS survey Tuesday is forecast to show further proof of a buoyant housing market, especially in the South East where property prices are currently rising at a faster rate than the country average. On this subject, we would not be surprised to read some comments in the MPC minutes on higher asset prices and the housing market in particular. Chancellor of the Exchequer Gordon Brown sounded optimistic two weeks ago on meeting his borrowing requirement for 2006/07 (even though he increased his borrowing estimate by £1.0bn to £36.8bn). We will keep an eye on the November public finances data on Wednesday to see if the Chancellor is still on target to meet his sums. The CBI distributive trades survey for December on Wednesday and may show a rebound from a disappointing November. The November survey was suspiciously out of line with upbeat ONS retail sales data last week. Having failed to capture stronger sales volumes last month, we expect the CBI survey to present a more promising outlook for December sales. Final Q3 gdp on Thursday is forecast to confirm the second estimate of 0.7% q/q and 2.7% y/y. Also on Thursday, figures are forecast to show that the Q3 current account deficit widened to £7.6bn from £7.0bn in Q2.

US economic data has recently surprised to the upside, forcing markets to reassess the outlook for interest rates next year. We will focus on the housing market data Tuesday for signs that the worst may be over and that the economy is experiencing a soft landing. Mortgage applications rose last week to the highest level since January, a sign that the housing market may indeed have bottomed. Monthly inflation data measured
by the core PCE index will be released on Friday and is forecast to show a rise in November to 2.5%.

The German December IFO survey will be published Tuesday and is forecast to have corrected some of the sharp gains in November. ECB president Trichet testifies to the European Parliament on Wednesday and is forecast to reiterate that upside inflation risks still exist.

The Bank of Japan is on Tuesday forecast to keep interest rates on hold at 0.25%.

Kenneth Broux, Economist
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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