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Monday February 12, 2007 - 12:16:39 GMT
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Economics Weekly: US housing market is on the road to recovery; Weekly economic data preview: Focus on UK Inflation Report & CPI and US Fed Bernanke testimony

Economics Weekly:

US housing market is on the road to recovery

US economy rebounding…

It is clear that US economic growth has returned to a 3% plus annual pace, somewhat above its long run sustainable, or trend rate, which we estimate as 2.75-3.0%. US money markets are no longer expecting the US central bank (the Federal Reserve) to cut short term interest rates in the first half of 2007, though the view further along the interest rate curve is still that the next move will be down. Our central view is that the next move in US interest rates could actually be up, on the basis that a US housing market recovery is already well under way and might remove the need for any rate cuts. Indeed, the pressure will be for a rise in US interest rates later in 2007 and early 2008, if the housing market does stage the kind of recovery we expect and begins to underpin consumer spending via greater confidence effects and renewed mortgage equity withdrawal.

…despite weakness in construction, the housing market is showing signs of recovery…
Concern about the potential weakness of US economic growth stems from the evidence shown in chart a. In all of the last six US recessions, the construction sector has been a good lead indicator of the wider economic downturn, but it has also sent one false signal (in 1966). Is it doing it again this time? We believe that the US housing market has turned, without the economy experiencing a recession. Mortgage applications and mortgage approvals are both now pointing sharply upward. Chart b shows this quite clearly. In addition, chart c shows that new and existing home sales are trending higher, based on three month moving averages that best pick up turning points. Chart d even shows that, at the national level (though by no means in all states), US house price inflation may have stopped falling and could be picking up. Are these indicators, though, simply reflecting a false dawn? That is possible, but would require in our view quite a sharp turn of sentiment and economic trends to lead to renewed housing market weakness.

…the explanation lies in a strong labour market and still relatively low interest rates…
What is going on? In our opinion, it is clear that the key to what is possibly a remarkable turnaround in the performance of the US housing market is continued growth in the wider economy, despite the sharp fall shown in construction activity. This is best illustrated by looking at consumer and business investment spending versus construction activity in annual growth terms, where the latter are rising strongly. What is maintaining consumer and business confidence? The answer is fourfold. One, US employment continues to grow and unemployment to fall, see chart e. Two, US company profits remains high and business confidence robust, see chart f. Another reason is that short and long term interest rates in the US, although higher than for some years, are still very low in terms of the last 20 years, see chart g. Finally, the US is running a fiscal deficit, supporting public spending. These factors are underpinning the recovery in the US housing market, and we think make the pick up currently underway a sustainable one.

…that are leading the whole economy to shrug off a recession in the construction sector for
the first time since the 1960s.

Our forecast shows that US economic growth will be around 2.9% p.a. this year, accelerating in 2008 to around 3.3% p.a. If so, see chart h, the US housing market will continue to recover and, we think, with a lag of some six to nine months, construction activity will also be picking up. If so, why would the US Fed be cutting interest rates at all this year or next? At best, any rate reduction is likely to be modest, but an equally modest rise first is also likely. Hence, US short term official interest rates may remain at current levels for some considerable time.
Trevor Williams, Chief Economist
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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Weekly economic data preview

Focus on UK Inflation Report & CPI and US Fed Bernanke testimony

• Why did the BoE leave interest rates unchanged last week? We expect next week's January CPI, made available at the MPC meeting, could have remained at 3% or below. Further, the Quarterly Inflation Report (QIR) could have projected CPI inflation to fall back to the 2% target in the medium term. As we discuss below, such a projection for CPI means that energy price inflation must fall more sharply than previously anticipated. However, the case for higher UK rates remains intact.

• A raft of US data are due next week, including the trade balance, retail sales, industrial production and housing starts/permits (see the Economics Weekly for a discussion about the US housing market). Fed Chairman Bernanke will also testify to Congress and will reveal new forecasts for GDP and inflation. We expect signs of stabilisation in the housing sector to continue and that the Fed will keep interest rates on hold in the coming months, but there is a risk of a bias to tighten emerging.

• The first estimates of Q4 GDP for the euro area and its main economies are expected to show a healthy pace of growth, with overall 2006 growth for the euro area forecast at 2.7% compared with 1.5% in 2005. As such, the ECB is expected to maintain its bias towards higher interest rates, with a quarter-point rise to 3.75% expected next month. The German ZEW survey is also due.

• In Japan, Q4 GDP and the deflator are due. We expect growth to rise 0.6%, following 0.2% in the prior quarter. However, the deflator is expected to remain in negative territory at 0.5%y/y. Therefore, we expect the BoJ to leave interest rates unchanged at 0.25% later this month.

Although the BoE decided not to surprise the markets by raising rates for the second time in as many months last week, the case for further policy tightening remains in place. The MPC had two crucial pieces of information at its disposable in last week's meeting which the markets did not: the January CPI and the Quarterly Inflation Report (QIR). We expect annual CPI to have fallen to 2.9% in January from 3%. Although we had previously expected a rise to 3.1% in January, which would have prompted Mervyn King to write a letter to the Chancellor, we cannot square this with the MPC's decision to leave rates on hold last week. On the other hand, the RPI measure is likely to have risen further to 4.5% from 4.4%, because of higher mortgage interest payments.

As for the BoE QIR, the no rate change last week seems to suggest that CPI is projected to fall towards the 2% target in the medium term, otherwise why would the MPC not have raised rates again? The problem with this is that it implies a much stronger fall in the projected CPI profile than in the November Report. Can this justified? Not entirely, in our view, but this is what the Report may show to give MPC more time to assess the impact of the recent rate rises. Although oil prices have fallen since the last QIR, the fall has not been sharp enough to justify a significantly sharper decline in CPI projections. Further, higher market interest rate assumptions compared with November cannot, in our view, justify such a steeper fall in the CPI projections, since growth has turned out to be stronger than the Bank expected. UK retail sales are also due and we see another solid monthly rise of 0.7%, based on positive anecdotal evidence.

In the US, there will be a deluge of data releases, while Fed Chairman Bernanke's semi-annual testimony to Congress, including new forecasts for growth and inflation, will be closely watched. The trade deficit is expected to widen to $60bn, while retail sales and industrial production are forecast to rise 0.3% and 0.2%, respectively. We expect core PPI to rise only 0.1%, but the Fed rate cut agenda should remain on the sidelines with further signs of stabilisation in the US housing sector. We expect housing starts to be 1630mln in January, slightly down from 1642mln, but consistent with the view that the sharp downturn since early 2006 has halted. Overall, we expect the Fed to keep interest rates unchanged at 5.25% for most of this year. The Fed may reduce rates by the year-end, though the risk is skewed towards steady rates until next year or even higher rates.

Eurozone data centre on preliminary Q4 GDP numbers and the German ZEW survey. We expect overall eurozone GDP to rise 0.5%, raising the annual rate to 2.9% from 2.7%. The German ZEW is also expected to rise to -1 inFebruary from -3.6, marking the third consecutive rise, as fears of the negative impact of the German VAT hike seemed to have been overdone. The ECB is expected to raise rates to 3.75% in March and we expect another rise to 4% in the second quarter.


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