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Monday February 26, 2007 - 11:24:22 GMT
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Economics Weekly: Record trade deficit could lead to higher UK interest rates; Weekly economic data preview: US Q4 gdp likely to be revised lower, but underlying trend still positive

Economics Weekly:
Record trade deficit could lead to higher UK interest rates;

UK trade weighted exchange rate has been strong...
The UK’s exchange rate has been strong in the last few years, helping to keep down domestic price inflation, as mentioned by the Monetary Policy Committee (MPC) in the Bank of England’s February Inflation Report. Indeed, one of the assumptions behind the MPC’s view that price inflation will fall back to the 2% target over the period ending in 2009 Q1 is that the trade weighted exchange rate index (TWI) falls by only 1.7% over the period, from 106.1 at the time of the report to 104.3. But I would question whether this benign view is likely to be the actual outcome. The reason is the UK’s trade deficit, which hit £83bn last year, a record. The current account deficit, which reached £36bn, see chart a, was also a record in value terms, though not when expressed as a share of the economy (gdp).

...but has led to a worsening of the trade deficit...
The reality is that an external deficit this size and with this trend implies a weaker currency, higher price inflation and hence higher than otherwise interest rates. So if the exchange rate turns out to be weaker than the MPC is predicting, then its interest rate profile is too low for what is likely to be the inflation environment in two years’ time. We put some estimates on the TWI going forward, and its likely impact on inflation and interest rates in this briefing.

...this implies that the TWI could fall sharply...
Over time, a country’s currency adjusts to reflect the change in its external trade and current account deficits. This is shown to be the case for the UK, in chart b, in terms of the current account, which is the main driver of the trade weighted index (TWI). In the chart, we have highlighted three main periods to illustrate how the relationship works. In theory, of course, the exchange rate is reflecting the price of UK goods and so if there is a trade surplus it means that demand for UK goods has gone up and that the exchange rate will eventually rise in response. The opposite is also true – a persistent trade deficit implies that the price of goods being sold abroad is too high and that the exchange rate needs to and, in a free market, will fall.

...and history shows that there have been periods of a sharply lower TWI...
This is the case for the UK’s TWI over time, as chart b shows. Examination of the last 30 years shows there has been quite a lot of shifts in the exchange rate and consequently in the UK trade deficit. In period 1, a rising TWI (1979-1981) leads to a worsening of the current account deficit in the following 8 years (1981 to 1989). In period 2, the fall in the TWI continued and led to an improvement in the trade deficit. In period 3 - the one we are currently in - the TWI is strong and its rise has led to a worsening of the UK’s trade deficit. This more recent period, since 1997, is shown in chart c, implying that at some stage and for whatever reason (i.e. a triggering event), the UK’s TWI has the potential to fall quite sharply, and by more than the 1.7% being suggested by the MPC in the February Inflation Report. In chart e, our estimate shows the fall could be quite severe.

...such an event now would push up inflation and interest rates...
The question is: what would this mean for price inflation and hence for short term interest rates? The reason why this question needs to be asked is that a weaker exchange rate leads to higher price inflation and higher interest rates, as shown clearly in chart d. We have modeled what the widening of the UK’s trade deficit implies for the TWI and it shows that the index could fall by 5% over the next two years, 3.3 percentage points more than the MPC is expecting.

...and our model suggests it could add some 3/4% to base rates over the next 2 years
What would this mean for UK inflation and so short term interest rates? We estimate that such a fall would add nearly 1% to UK inflation over the period, if it occurred immediately and was sustained for 2 years, and so could add some 75 basis points to short term interest rates. In current terms, this would imply that 2 year money market interest rates could rise to 6.12% and base rates would have to rise to 6% to get inflation back down to the 2% target over the 2 year time horizon. This is, of course, an extreme outcome but it is not beyond what is possible, if the financial markets took fright at the UK’s trade deficit and sold the currency. It would raise UK price inflation and mean domestic interest rates would have to be higher in order to compensate for the rise in imported inflation. The charts used here do show the UK TWI has been very strong in the last few years but it would be foolish to bet that this situation can continue, especially with the external deficit getting wider. It implies that setting interest rates in the next few years will be decidedly more challengingly for the MPC than in the last decade and that we should be prepared for interest rates, on average, to be higher.
Trevor Williams, Chief Economist

Weekly economic data preview
US Q4 gdp likely to be revised lower, but underlying trend still positive

• The second estimate of US Q4 gdp growth is due on Wednesday, with most forecasters expecting a sharp downward revision to last month's preliminary estimate of 3.5%. However, the key point is that personal consumption held up well and with signs of recovery emerging in the US housing market, the trend will be for economic growth to strengthen in 2007. The gdp deflator may also be revised after falling to the lowest for more than three years in Q4 2006, at 1.5%. However, more attention may be taken by the core PCE deflator, the Fed's preferred inflation gauge, which rose by an annual rate of 2.1% in Q4 2006. The monthly core PCE deflator is due on Thursday for January.

• There are a series of other key US economic data due this week. On Tuesday, January durable goods orders and existing home sales will provide a guide to how the economy is shaping up in Q1 2007, while consumer confidence in February should be underpinned by continuing solid employment growth. The Chicago PMI, on Wednesday, is expected to show manufacturing activity picked up in February and will provide a key pointer to the manufacturing ISM on Thursday.

• Economic releases in the UK this week should have a firm tone. For the Gfk consumer confidence index, on Wednesday, we project a further improvement in February to -6. Housing market data is likely to remain buoyant, with the February Nationwide house prices index due on Wednesday and January net mortgage lending and approvals data on Thursday. The manufacturing PMI, on Thursday, may show stronger activity in February. The CBI Distributive trades' survey, also on Thursday, may surprise after its sharp rise contrasted with a fall in official retail sales in January.

• It is a busy week for economic news from the euro zone. The highlights are January M3 money supply data on Tuesday and the 'flash' CPI estimate for February on Thursday. A raft of survey data is due on Wednesday and Thursday and should overall support the current economic optimism prevailing after economic growth peaked to its highest in six years in Q4 2006. Prospects for further interest rate rises from the ECB remain strong, starting with a hike to 3.75% next month.

The US economy is proving more resilient than many forecasters predicted last year and growth could near 3% in 2007, slightly stronger than its long run trend rate, which we estimate at 2.75%. This is clearly more important now than how growth fared last year and financial market participants should appreciate this ahead of the likely sharp revision to US Q4 2006 gdp data on Wednesday. The preliminary estimate last month showed annualised Q4 gdp growth at 3.5%, up from 2% in Q3 2006. However, weaker than expected external trade data for December have primarily underpinned a market view that Q4 2006 gdp could be revised down to just 2.3%. We are more optimistic and look for a reading closer to 2.8%. The Q4 2006 gdp deflator could also be revised up from a three year low of 1.5%.

US personal consumption rose by an annualised 4.4% in Q4 2006, underpinning the rebound in gdp growth, and we believe this resilience in the face of the sharp downturn in the US housing market is perhaps the most crucial factor behind growth prospects in 2007. Data for January existing home and new home sales this week should support the view that the housing market is now recovering and that the worst may be over (see chart). The strength of domestic demand may also ensure that the Fed's preferred inflation gauge, the core PCE deflator, remains stubbornly above their stated comfort level (1-2%), limiting any scope for interest rate cuts. We look for the January reading to rise to 2.3%, from 2.2% in December, on Thursday. The Chicago PMI fell below 50 (contraction) for the first time since April 2003 last month, however we forecast an increase to 50 in February. The manufacturing ISM, on Thursday, should also rise back above 50, after falling to 49.3 in January. Durable goods orders and consumer confidence are due out on Tuesday.

U K data are few this week and unlikely to be very market moving. bGfk consumer confidence may have improved for a second month, reflecting favourable recent labour market trends. Mortgage lending and approvals data, on Thursday, should remain buoyant. The manufacturing PMI is expected to show activity picked up in February, supported by both solid export orders and strong domestic demand. The CBI Distributive trades' survey, on Thursday, will offer a first glance at high street sales in February, but its correlation with official retail sales data has been mixed of late.

Economic news from the euro zone this week is expected to support the positive outlook for the region and for further interest rate hikes later this year. The highlights of a busy calendar are January M3 money supply data on Tuesday and the 'flash' CPI estimate for February on Wednesday.
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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