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Monday January 15, 2007 - 12:55:49 GMT
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Economics Weekly: UK growth to be robust in 2007, Weekly economic data preview: Did stronger UK CPI inflation push the MPC to raise rates?

Economics Weekly:

UK growth to be robust in 2007

The latest rise in UK interest rates to 5.25% was the first January increase since 2000, taking base rate to its highest level since July 2001. Bank base rate has now been raised three times since August 2006. Our view is that faster UK economic growth and higher inflation justify the rate increases, but also that growth in 2007 will remain healthy despite higher rates. Although there seems to be a consensus view that UK economic growth will slow from last’s year’s pace of 2.6% or so to 2.3% in 2007, we fundamentally disagree with this, seeing growth instead accelerating to 2.9% this year. But inflation may also be higher and it is this fear that has led the Bank of England to raise interest rates. What are the reasons for our projection and what does it mean for inflation and interest rates?

Sustained growth since 1992…
UK economic growth has been remarkably strong in the last 15 years, and is currently experiencing the longest period of sustained growth since the 1950s, see chart a. In fact, in no quarter since 1992 Q2 has UK economic growth been negative. This is a remarkable performance, due to a number of factors, not least low global inflation and the emergence of China and India as low cost producers of manufacturing goods and services. But better management of the UK economy by policy makers (both monetary and fiscal) has also played a crucial role, like, for instance, giving the Bank of England independence.

...has been helped by low global inflation
A lower inflation environment in the UK since the 1990s than in the 1970s and 1980s has led to higher employment and higher productivity. Investment spending has been strong and companies more willing to invest and so hire, while low interest rates as a result of low inflation has encouraged consumers to borrow and spend more (in other words lower their saving ratio). This has been the experience of the UK in the last 15 years, with unemployment falling to the lowest levels since the 1970s and the personal sector saving ratio to a 40 year low, see chart b.

With employment and productivity as high as any time in last 30 years
Economic growth can be viewed as a combination of employment growth and productivity gains. The combination of the two also exactly match the 2.5% pace of annual average UK growth since 1956, as shown in chart a. Looking at the performance of the UK economy in this way shows that since 1992 productivity gains and employment growth have either matched or surpassed their respective long run performance, see chart c. In the 1970s and the 1980s, however, they were well below average, explaining the poor performance of the UK economy in these periods.

Economic growth to improve in 2007…
We believe that the global growth background remains very favourable, with the UK’s biggest export market of Europe (55% of exports) likely to expand by 2.3% and the US (15% of exports) by 2.9% on our forecasts. World growth does slow in 2007, but only to 4.6% from 5.2% in 2006 and will remain well above the long average of 3.4%. Oil prices are also expected to be lower and so will support growth as income is transferred from producers to consumer and additionally help bear down on price inflation. The latter will ease pressure on the MPC to raise interest rates to levels that do too much damage to the domestic economy, but will not prevent rates rising as has been proved. But the rate rises will not lead to recession because growth is already healthy, led by employment gains, increased investment and exports.

..though higher interest rates are required to ensure inflation stays low
Hence the Bank of England was right to raise interest rates as faster growth, 0.7% in each of the last five quarters to end 2006, has lifted the UK economy’s output gap (actual growth relative to potential) from negative to positive. In other words, instead of exerting downward pressure on inflation (a negative output gap), a positive output gap is now generating upward pressure on inflation in the UK, see chart d. This is what the MPC fears: that with price inflation above target, and likely to accelerate further in the months ahead before subsiding, it needs to take action to keep growth in line with the economy’s capacity. Otherwise, the current round of pay negotiations could see higher price inflation embedded in the economy, leading to a vicious upward cycle for inflation. But with oil prices lower and productivity growth solid, our view is that UK inflation will be heading lower by the end of the year, though unlikely to fall below the 2% target until 2008. Moreover, with UK consumers facing high levels of debt, household spending will likely rise by only around 2.5% in 2007, well below the long run average of 2.8% and the 10 year average of 3.5%. That means overall UK economic growth will be above the long run average of 2.5% only due to continued growth in company investment spending. The latter also adds to the UK economy’s productive capacity and is hence good news for the sustainability of economic growth. In any event, chart d shows that the UK’s inflation performance for every level of the output gap has been much better since the 1990s and so inflation should be modest, so long as interest rates are kept at an appropriate level.

Imbalances resulting from the longevity of UK growth will not derail the economy
It is also worth noting that other signs of the long period of growth are also evident in the UK economy, with the current account deficit at 3% of gdp and the government fiscal deficit at a similar level. These are but two of the risks that may undermine UK economic growth in 2007, although it is also worth noting that, looking at chart e, these imbalances as a share of gdp are much smaller than was the case 15 years ago. This is another reason why, in the absence of a global inflation shock or financial market event or other shock, we see good conditions for solid growth in the UK during 2007.
Trevor Williams, Chief Economist

Weekly economic data preview

Did stronger UK CPI inflation push the MPC to raise rates?

• The Bank of England raised interest rates by 0.25% to 5.25% last week but surprising financial markets and commentators only with the timing of the move, not the increase. Did information not yet available publically push them into an early move? Data to be released this week will make it clear whether this was the case or not. We look for bank rate to rise to 5.5% in May 2007.

• Comments from ECB president Trichet at last week's press conference after the interest rate decision (rates left at 3.5%) strongly hinted that euro zone interest rates will also be kept on hold in February. We maintain our view that interest rates are most likely to rise to 3.75% in March.

• Bank of Japan officials have provided limited guidance on the outcome of this week's monetary policy meeting. While we expect interest rates to remain on hold, the decision may be finely balanced and financial markets could get another surprise. The Bank of Canada is expected to keep interest rates unchanged at 4.25% on Tuesday.

• US economic news will take centre stage from Wednesday, with a series of key economic data due and some prominent Fed speakers. Financial markets will be interested to see whether these reinforce the more positive outlook provided by recent data releases and comments from Fed officials regarding US economic prospects in 2007.

The decision by the BoE to raise interest rates last week to 5.25%, rather than wait for the analysis and forecasts provided by the February BoE Inflation Report, surprised financial markets, driving up sterling and bond yields along the curve. However, it was its timing, rather than the hike itself, which proved surprising but also intriguing, as a sizeable minority of economists and the financial markets were confident that rates would not be raised until next month. The MPC would have known this and also understood that a hike now would see the markets react by pricing more aggresively for further increases. The press statement accompanying the decision provided no clear clues to their reasoning, but did highlight that 'relative to the November Inflation Report, the risks to inflation now appear more to the upside'. This has raised suspicion that Tuesday's December inflation data, which the MPC will have already seen, could show a further acceleration above the 2% annual CPI target and the 9-year high (2.7%) seen in November. The chart below shows that all the main UK inflation measures have picked up in recent months and we expect higher inflation in December, with CPI at 2.8% and RPI at 4.2%, above 4% for the first time since 1998. The outlook for wage growth will have been at the forefront of MPC discussions last week and they could also have had access to Wednesday's labour market statistics. We look for annual growth in 3-month average earnings including bonuses at 4.3%, from 4.1% in October. There are some other key economic releases next week, on Friday, which the MPC may not have seen. Survey and anecdotal evidence suggest that the high street fared well last month and we look for a solid 0.7% rise in December retail sales. BBA and CML mortgage lending figures, December M4 money supply and public finances data will also attract attention on Friday. Economic data over this week and the MPC meeting minutes next Wednesday will help to better assess the outlook for further interest rate rises this year. However, we now expect bank rate to hit 5.5% by May 2007.

Comments from ECB president Trichet last week at the monthly press conference suggested that euro zone interest rates are likely to stay on hold at 3.5% in February. Economic news from the region this week is limited and unlikely to change this view. We maintain our call of 3.75% rates in March, but the ECB can afford to wait.

The BoJ could spring a surprise this week but we expect interest rates to remain at 0.25%. However, the decision is finely balanced in the view of financial markets. The rise in Japanese official rates is likely to proceed slowly. The BoC is also expected to keep interest rates at 4.25% on Tuesday.

US economic news has been more favourable recently and improved prospects for growth have supported the dollar and reduced expectations of cuts in official interest rates. The focus this week will be mainly on inflationary pressures. We forecast core CPI accelerated to 2.7% in December, up from 2.6% in November. Housing starts and building permits data, also due on Thursday, are expected to have fallen back from November. International capital flow data, on Wednesday, will attract some attention and University of Michigan confidence, on Friday, promises a nervy close to the week. Fed speakers could also elicit strong market reaction.
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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