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Monday January 29, 2007 - 11:05:24 GMT
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Economics Weekly: Inflation in the UK could rise more than the MPC expects. Weekly economic data preview: US rate decision the highlight of a key week for financial markets

Economics Weekly

Inflation in the UK could rise more than the MPC expects

What is happening to inflation in the UK? In the last few months, UK consumer price inflation (CPI), which has been below EU-12 inflation since 1999, has since jumped above and now stands at 3% compared with 1.9% in the eurozone. What has led to this acceleration and where might it end? Through a series of charts we look at the key influences on UK inflation, concluding that CPI inflation may stay above the 2% target all this year and that with inflation a threat and price expectations rising, the Monetary Policy Committee (MPC) may have to push rates up to 5.75% if they do not act quickly.

UK economic growth has been strong, so the economy no longer has any spare capacity…
The UK has experienced positive economic growth since 1992, albeit showing periods of fast and slow growth (ranging from a high of 4.3% in 1994 to a low of 1.9% in 2005). This has led the UK to a position where continued economic growth is now generating higher consumer price inflation, see chart a. But why is this happening now and not before? Chart b shows that one of the reasons why the current pace of growth is generating inflation is that the UK has a positive output gap. What does this mean? If the UK is operating with spare capacity then it has a negative output gap (actual output is less than potential output) and this puts downward pressure on price inflation. But if the economy is operating with no spare capacity, a positive output gap (actual output is above potential), then this will lead to upward pressure on inflation.

...Interest rates have responded but are the increases so far enough?
Chart c shows that interest rates have been raised in response to the acceleration in consumer price inflation, but has this been enough? Chart d shows that all measures of UK inflation are now trending higher, with the notable exception of wage inflation. But can it stay low when all other inflation measures are rising - this seems unlikely. One reason why the Bank of England continues to believe that UK price inflation can fall back sharply in the second half of 2007 is that oil prices are now declining, see chart e. The chart illustrates that oil price falls do have a link with inflation and that the latest fall should lead to some downward pressure on price inflation.

Rising consumer price expectations suggest that the risk of inflation accelerating further is high…
But there are also other reasons to be concerned about UK price inflation. Chart f shows that import prices have risen into positive territory, albeit now slowing, and this has pushed UK retail sales price inflation from negative to positive territory, see chart g. Since goods prices account for 55% of the consumer price index compared with 45% for services prices (worryingly, these are now rising too), this means that overall price inflation will pick up. Unfortunately for the MPC, this deteriorating environment for inflation is now embedded in household expectations, see chart g.

...and that interest rates may rise a further ½% before peaking
The Lloyds TSB measure of consumer price expectations shows a similar outcome to the BoE NOP measure, see chart i. Based on the link between expectations and actual interest rates, households are implicitly expecting official short term interest rates to peak at 5.75%, ½% above the current of 5.25%. Another way of looking at this is, if the Bank of England wants to be seen to act tough, given consumers inflation expectations, base rates have to be raised to at least 5.75%. This is not the sentiment that we are getting from some MPC members, who seem to think that they only need act if wage inflation picks up. The analysis in our weekly suggests, first, that waiting for proof that wage inflation is not responding means it may be too late to act if it does rise and then retail price inflation could hit 5% or more. Second, current high consumer price expectations make it more likely that wage inflation will pick up and that the peak in base rates will be higher the longer the MPC waits before acting. The MPC is in a difficult position.
Trevor Williams, Chief Economist

Weekly economic data preview

US rate decision the highlight of a key week for financial markets

• The US FOMC interest rate decision, late on Wednesday, takes centre stage in a busy week for economic news. Although interest rates are likely to remain on hold at 5.25%, financial markets will be alert to any significant changes in the accompanying statement and the voting pattern, particularly since Lacker (who voted for a rise at the previous four meetings) has now left the voting committee.

• A series of key US economic data could pressage a fairly volatile week for financial markets. The first estimate of Q4 2006 gdp, on Wednesday, could spring a surprise and the 'core' PCE deflator, on Thursday, will also be watched closely. January non-farm payrolls, due on Friday, could show 140,000 new jobs were added, but the unemployment andm earnings data will also attract attention.

• It is a quiet week for key UK economic releases. The CBI distributive trades' survey, on Monday,will offer a first view of high street sales in January, and we expect a strong outturn. Robust bank lending data, on Tuesday, should support the positive outlook for the housing market in 2007. The manufacturing PMI, on Thursday, may show manufacturing expansion continued for an 18th month.

• Recent euro zone economic data have strengthened our view that the ECB will raise interest rates to 3.75% in March. The 'flash' estimate of January CPI, on Wednesday, could show the annual rate edged back at 2% for the first time since August. French and German unemployment should show further falls, while another set of strong regional manufacturing PMIs are expected on Thursday.

Recent US data have supported our long-standing view that the economy is only likely to experience a modest slowdown in 2007. Although the housing market remains a key vulnerability, we believe that a soft-landing is still possible and that the worst may already be over. Financial market expectations currently suggest the probability of a cut in US interest rates in the first half of 2007 is below 10%, sharply down from almost 50% in mid- December. The dollar has rallied since the start of 2007, on the back of the more favourable outlook for the economy and higher interest rates. The change in market perceptions about interest rates since the last FOMC meeting in December may come under strong scrutiny this week. Although the Fed is overwhelmingly expected to keep interest rates on hold at 5.25% for the fifth successive meeting on Wednesday, the accompanying press statement will draw keen attention. Any significant changes to the tone or language used compared to December could elicit strong financial market reaction. Another key factor may be the voting pattern, with three replacements on the FOMC committee, and with Lacker leaving in particular (he voted for a hike at the last 4 meetings).

Preliminary US Q4 2006 gdp data are due earlier on Wednesday. After slowing in the previous two quarters, a rebound in gdp growth to 3.2% is expected, underpinned by stronger net external trade and a reduced drag from residential investment. Inflation will also be in focus this week, with the Q4 gdp and PCE deflators forming a key part of the gdp report and the December 'core' PCE deflator on Thursday. The US labour market report promises a nervy Friday. We forecast 140,000 non-farm jobs were added in January, down from 167,000 in December. Earnings data and the unemployment rate will also attract attention. The underlying strength of the US labour market and rising earnings are two key reasons why we believe the chances of an interest rate hike this year, has moved higher in recent weeks. Consumer confidence and ISM manufacturing are also due this week.

The strength of consumer spending is a key focus in the UK this week. On Monday, the CBI distributive trades' survey is expected to show high street spending remained buoyant in January. We look for the headline index to ease to 22, from 25 in December. Bank lending figures for December are due on Tuesday and are likely to show net mortgage lending and approvals remained close to 3-year highs, if slightly down on November. Net credit is forecast at around £1bn. Falling unemployment and rising employment may have led to slightly stronger consumer confidence (Gfk) in January, due on Wednesday, despite higher interest rates. The manufacturing PMI, on Thursday, may have edged up to 52.0.

Euro zone economic data this week are expected to support our forecast of a hike in interest rates to 3.75% in March. The 'flash' CPI estimate, on Wednesday may show annual inflation rose back to 2% in January. Further falls are forecast in both French and German unemployment, due on Tuesday and Wednesday, respectively. Regional manufacturing PMIs, due on Thursday, should show continued solid expansion in January, led by a particularly buoyant Germany.
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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