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Monday February 5, 2007 - 13:58:39 GMT
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Economics Weekly: The economic impact of 6.5% UK base rates, Weekly economic data preview: Bank of England rate decision finely balanced, our bias towards hike

Economics Weekly: The economic impact of 6.5% UK base rates

Setting the scene
UK interest rates have increased by 0.75 percentage points starting in August last year to 5.25% currently. This has not yet slowed the economy. Why is this? And how high would base rates have to go if wage inflation accelerated and price inflation stayed above the 2% target? We consider what is the critical level of interest rates in this week's analysis.

Why base rates of 5.5% could get inflation back to target
The answer to the first question is that interest rate changes take anything up to 2-3 years to have their full effect on the economy, with the main impact coming through within 18 months. Hence, it is too soon for the increases seen so far to have a major discernible effect on the UK economy. Second, although inflation is a threat to economic stability and is, at 3% in the year to December 2006, 1 percentage point above the 2% target, we believe that there are good reasons why it will eventually fall back to the target. However, our view is that it will take another 0.25% increase in base rates, to 5.5%, to lead to this outcome in 2008 rather than this year. Lower global oil prices, the lagged effect of earlier increases in base rates and the heightened impact of interest rates on highly indebted UK consumers mean that inflation falls back to 2% in the second half of 2008 on our forecasts, with base rates peaking at 5.5%.

Why 6.5% base rates are so damaging
In the meantime, however, a major risk in our view is that base rates may have to rise to 5.75% or above, the longer the Bank of England takes to raise rates to 5.5%. Interest rates of 6 or 6.5% will weaken UK growth more than is necessary to curb inflation, and our calculations show that 6% is the tipping point and 6.5% leads to significantly weaker growth i.e. less than 1% in 2008, and inflation significantly undershooting the target. But why should interest rates of only ½% to 1% above our central forecast of 5.5% weaken the UK economy so much?

Our scenarios highlight why the impact of higher base rates could be so damaging
We attempt to answer this question in a series of charts from simulations using a large scale econometric model of the UK economy that illustrate a number of key points. Chart a shows that 6.5% interest rates lead to economic growth falling to 1% in 2008. (We assume that interest rates rise to 5.5% by March and to 6.5% by June and stay at that rate to the end of 2008). With 5.5% base rates, annual economic growth remains near 3% in Q4 2008. Chart b shows that with 6.5% interest rates inflation falls to well below the 2% target, to 1.1% by the end of 2008. Charts c and d show that consumer spending and company investment spending fall sharply with 6.5% interest rates and these will lead the UK economy lower. But why should these components of gdp fall so sharply? Charts e, f and g show that, for consumers or households, it is high interest payments, rising unemployment and falling house price inflation that lead to increased savings and so weaker consumer spending. Charts h, i and j show that, for companies, higher interest rates lead to a rise in gearing (interest payments as a share of profits), as debt payments go up and profits fall, which hits investment spending, amid falling manufacturing output.

Tipping point reached at 6%+ interest rates
It is for the preceding reasons that 6% interest rates is a tipping point for UK economic growth and hence so damaging – borrowing levels are high, with consumer debt never having been as elevated as at present. A rise in interest rates to 6.5% means that UK household interest payments reach the same level, 14%, of annual income in 1990, when we had record levels of house repossessions. The impact of slower growth in the wider economy on the company sector is self evident. The scenarios suggest that the risk to the economy of having to raise interest rates late are so great that the MPC should act early, and hope that it is enough.

Trevor Williams, Chief Economist

Weekly economic data preview

Bank of England rate decision finely balanced, our bias towards hike

• We believe the BoE interest rate decision this week is more finely balanced than currently suggested by financial markets and another 0.25% hike could be on the cards. Economic data since the January MPC meeting have generally proved stronger than expected and are supportive of a further hike. The BoE last raised bank rate in two consecutive months in May and June 2004.

• There are some important economic releases due ahead of the BoE rate decision on Thursday that could shift market expectations. If the UK services PMI, on Monday, shows a further increase above 60 then the possibility of a rate hike could rise sharply. The December industrial production data, on Thursday, could also be significant. It is worth noting the MPC will also have available to them a preview of the January inflation data and the forecasts from the BoE Q1 Inflation Report
• The ECB are widely expected to keep interest rates at 3.5% on Thursday. However, we expect ECB president Trichet to signal the possibility of a hike in March at the press conference. Recent data and comments from ECB members suggest further tightening ahead, despite CPI still below 2%.

• The payrolls data last week suggested unchanged US interest rates for some time. Data this week are few, but could be more important in assessing whether the next move will be up or down and how soon? The January ISM services index, on Monday, should show robust activity, albeit slowing slightly. Productivity and unit labour costs data for Q4 2006
are due on Wednesday.

We believe the Bank of England (BoE) will have to raise interest rates again in the first half of 2007 and could be pressed to act this week, given the strength of recent economic data and armed with the latest forecasts from the Quarterly Inflation Report (QIR). Although the decision to raise bank rate to 5.25% at the January Monetary Policy Committee (MPC) meeting was close (5-4), we believe some members only chose to wait for the next QIR rather than disagree with the need for higher rates. Recent comments from BoE governor King have also tempered market expectations of a possible hike this week, but it is worth noting that he had the casting vote in January and chose to wrong-foot the financial markets who were looking for a rise in February. With inflation running well above the BoE's 2% target, and we believe soon likely to surpass 3% (possibly in January) to force governor King to write an explanatory letter to the Chancellor, and accelerating economic growth amid limited spare capacity, why should the MPC not hike rates to 5.5% this week? The only reason we can propose is still strong conviction that inflation will come down sharply in the second half of the year, but how justified is that ahead of an uncertain pay round and signs of rising inflation expectations? We also believe that the latest QIR is likely to be more hawkish than in November. However, if the MPC decide not to raise bank rate this week, we believe it is only a matter of timing and expect it to be raised at least once more in the first half of 2007.

UK economic data this week could raise market tension ahead of the BoE interest rate decision on Thursday. The services PMI, on Monday, rose to a near 10-year high in December and we expect another robust outturn for January. With both the manufacturing and construction PMI indices rising last week, a strong services PMI would signify that economic growth has picked up again in 2007 and should send a warning signal to the MPC. Industrial output data, on Thursday, are less important but could still be significant, if growth rebounded by more than expected in December. Trade data, on Friday, may show another goods deficit above £7bn in December.

The European Central Bank (ECB) is not expected to spring a surprise on Thursday and interest rates should remain at 3.5% for a second consecutive month. However, financial markets will be alert to Mr Trichet's comments at the press conference, where he is expected to signal the strong possibility of another 0.25% increase in March. Recent economic data from the region suggest economic growth will withstand tax rises in Germany and Italy and general monetary conditions still appear accommodative. Annual CPI is just below 2%, but is expected to accelerate in the months ahead.

It is a relatively quiet week for key data in the US. The non-manufacturing ISM, on Monday, may have eased back in January but should show continuing firm activity. The Q4 2006 productivity and unit labour costs data, on Wednesday, will be closely watched to gauge prospects for inflation. Data this week are unlikely to change our view that US interest rates are likely to stay on hold at 5.25% for a while longer yet, but may have implications for the dollar.
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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