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Monday April 23, 2007 - 11:00:46 GMT
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Forex Market News - Economics Weekly: UK inflation tops 3% for the first time in ten years, Weekly economic data preview Q1 gdp likely to bolster case for May rate rise

Economics Weekly:

UK inflation tops 3% for the first time in ten years


Overview
In April, the Bank of England had to write its first open letter to the Chancellor of the Exchequer, Gordon Brown, explaining why inflation has gone above the 2% target by more than 1%. What is remarkable about this is not that the letter had to be written at all but why, as the Governor said in his letter, ‘…that is has taken ten years and 120 meetings of the Monetary Policy Committee’. This is a testament to the skill of the MPC but it has also been operating in an environment of low global inflation, helped by the emergence of India, China and a host of other countries. But the MPC’s job will now become more difficult and challenging, as the largest part of the negative effect on price inflation of global competition begins to fade.

Could the MPC have headed off the recent rise in inflation?
Indeed, it could be argued that the MPC could have headed off this rise in inflation had it acted pre-emptively. But the world background is still one of low inflation and UK growth is not experiencing boom conditions, nor is the expansion particularly inflationary, so our forecast suggests that the MPC should be successful in bringing inflation back close to the 2% target in two years’ time. However, UK interest rates need to rise further in the short term, and may also remain higher on average over the next few years than was thought likely a few months ago.

Where did it go wrong?
Chart a shows that UK inflation is now more than 1% above the 2% target, for the first time since the Bank of England was made independent in 1997. Chart b shows that, breaking down the CPI into services price inflation and goods price inflation, the biggest change has been in goods prices. Services price inflation (housing services, recreational services, etc) has been roughly stable between a 3-4% annual range in the last few years. But goods price inflation is no longer falling as strongly as it once was, and it instead rose by 2.5% in the year to March 2007, compared with a fall of 0.2% just two years ago. Why has goods price inflation picked up? The answer appears in chart c, which shows that energy goods prices have rocketed, especially at a time when the UK is no longer energy self sufficient and is now importing oil and gas. But the chart also illustrates a second point about the change in inflation in the last few years: non energy goods prices are no longer falling as much as they were. Hence, it was no surprise for us to see that ex food and energy, or so called core CPI, see chart d, also hit its highest levels since 1997 in March 2007.

UK economic growth is above trend and exerting pressure on inflation
This increase is due to a number of factors, some external, despite strong sterling, but there is also another reason, as shown in chart e. The UK economy has now used up all of its spare capacity and so economic activity is exerting upward pressure on domestic price inflation. When the output gap (actual output relative to potential output) is negative, inflation tends to fall, when the output gap is positive, price inflation tends to rise. This is showing up in a variety of ways, not least in firms’ output price inflation rising at its fastest pace in many years; surveys suggesting that companies feel that they can expand profit margins and in the strong rise in business investment. Companies are trying to add to capacity because they feel that demand is strong enough to justify it and are trying to increase prices for the same reason. Labour demand is strong because economic growth is above trend, i.e. 2½% a year, and so the pressure on wage inflation is likely to be upward. And fast growth in M4 is also consistent with above trend growth in UK gdp and a positive output gap. Chart f does show, however, that despite the rise in total wages, which includes bonuses, ex bonus pay growth is still not excessive. This implies that high inflation has not yet been embedded in the UK’s pay and bargaining process. In turn, this suggests that if the MPC acts early and aggressively, annual price inflation could be brought back under 3% without excessive tightening.

Can the MPC control inflation without significant rise in base rates?
It must be remembered that UK interest rates have come up from 3.5% in 2003 to the current 5.25%, with 5.5% likely in May. The problem has been that the pace of monetary tightening has fallen behind that of the acceleration in price inflation. This has opened up a risk of needing to raise base rates by more than otherwise, and in this sense the MPC can perhaps be blamed for not being aggressive enough earlier. Chart g confirms this, implying that the monetary policy stance (policy is loose when base rate is below nominal growth in gdp, and vice versa) has been below that of nominal growth in gdp since mid 2006, so inflation has picked up. But our forecast shows that all is not lost; if base rates are raised to 5.5% in May, and kept there all year, then money gdp will fall back in 2008, so that interest rates do not have to rise to 5.75% or 6%, which is now a major risk. Finally, chart h shows that on our monthly inflation forecast, consumer price inflation does fall well below 3% in the second half of the year, strengthening the possibility that the MPC need not raise interest rates at its August meeting. But chart g also suggests that UK interest rates may only be cut to 5% next year, even on the assumption that economic growth weakens to 2½%. The era of ultra low UK interest rates appears to be over.
Trevor Williams, CHief Economit

Weekly economic data preview

Q1 gdp likely to bolster case for May rate rise

• Financial markets are fully discounting a 0.25% UK rate rise in May to 5.50% and have raised the odds of another increase in the second half of 2007 after the increase in CPI inflation to 3.1% in March. Preliminary Q1 gdp will be released on Wednesday and is expected to add to the case for a May move. However, we think a second move to 5.75% is unlikely at this time. The CBI industrial trends survey is due on Tuesday and could show some concerns among exporters about the rise in £/$ above 2. The second part of the MPC testimony to the Treasury Select Committee on '10 years of monetary policy' takes place tomorrow.

• A busy week for US data includes releases of consumer confidence and existing home sales on Tuesday, and new home sales on Wednesday. The advance estimate of Q1 gdp is due on Friday and may show that economic growth stabilised close to the 2.5% annualised level of Q4 2006. Fed chairman Bernanke speaks in Washington on Wednesday ahead of the publication of the Fed Beige Book.

• In the euro zone, markets will concentrate on the German IFO survey of business sentiment on Wednesday and German April CPI data later in the week. A robust global economic backdrop and strengthening domestic demand suggest the German IFO may have improved to a 4-month high and should bolster confidence over the economic outlook at the start of Q2.

• Interest rates are likely to stay on hold this week in Japan, Canada and New Zealand. The release of Australian Q1 consumer prices may weigh on expectations of a rate rise by the RBA to 6.50% in May. Interest rates in Norway are forecast to rise 0.25% to 4.25%.


The testimony by the MPC on Tuesday and the first release of UK Q1gdp on Wednesday head up the UK calendar but may not have significant implications on the outlook for interest rates in May. The report of a 3.1% rise in annual CPI in March and a 7-2 vote by the MPC in April, with no prior knowledge of the March CPI figure, means a rate rise in May now is a near certainty. This week's gdp release, which we expect to show that above trend growth continued in Q1, is likely to strengthen the argument for a rate rise in May. This message could come across during the testimony to the Treasury Select Committee tomorrow where Bank of England policy setters will discuss the legacy of 'ten years of monetary policy'. We expect gdp growth to have increased by 0.7% in Q1, matching the performance of Q4 2006. This would correspond to a modest decline in annual growth to 2.9% from 3.0%. Last week's rise in £/$ to a 26-year intra-day high of 2.0133 could weigh on the latest CBI industrial trends survey on Tuesday. A substantial improvement in export orders was behind the rise in optimism this winter but concerns about the sterling exchange rate and the competitiveness of UK manufactured goods and services overseas and the impact on foreign earnings could result in a decline in the CBI survey from last month's 12-year high.

Discussions about the US housing market, business investment and consumer confidence will take centre stage this week and is likely to impact the dollar and speculation about Fed policy. US data has started to turn slightly more positive since the start of April and we are optimistic that this trend could manifest itself in this week's durable goods orders and labour market data. Existing home sales are forecast to have eased back in March after consecutive increases in the previous three months. New home sales which account for a much smaller proportion of the entire residential property market, are forecast to have rebounded in March after successive declines in January and February. Housing starts and building permits both surprised to the upside last week and support our view that the housing market has bottomed. Durable goods orders for March are due on Wednesday and are forecast to have increased for a second month, still recovering from the 8.8% correction in January. The advance estimtate of Q1 gdp is due on Thursday and may show a further slowdown in growth compared to the previous quarter due to weakness in business investment and residential construction.

The German IFO business survey will attract most attention in the euro zone. After a surprise increase in March, we expect confidence among industry leaders to have improved again in April. The question is to what extent the strength of the euro is starting to weigh on competitiveness. So far, ECB officials have played down the strength of the currency, citing strong global and domestic demand.
Kenneth Broux, Economist

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
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