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Monday June 25, 2007 - 11:13:25 GMT
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Economics Weekly:UK consumer price inflation - how a policy mistake occurred; Weekly economic data preview: US interest rates to stay at 5.25%

Economics Weekly:

UK consumer price inflation - how a policy mistake occurred

Measures of inflation matter
Total consumer price inflation is falling in the UK – from the peak of 3.1% in the year to March it has fallen to 2.5% in May. However, consumer price inflation is still rising when measured in terms of ‘core’ prices, which excludes food and energy, see chart a. What are we to make of this, which measure matters the most or do they matter equally? In the US, core consumer price inflation seems to matter the most to policy makers and the financial markets seem to agree with this because although the headline rate jumped 0.7% in May, bond market prices actually rose on the news and yields fell on the basis that the rise in core inflation was less than expected (+0.1%). Moreover, the US Federal Reserve, the central bank, is also focused on core inflation, rather than the headline rate.

All categories of inflation are important guides for policy makers…
In the UK, however, the Governor of the Bank of England, Mervyn King, said in a recent speech that whatever the source of inflation it is of concern to policy makers. Since UK interest rates have already been raised by 1 percentage point to 5.5% from 4.5% last year, this is an important issue, as it will influence the extent to which UK interest rates are raised further. What has been happening to the categories that make up the headline index of consumer price inflation in the UK and what do they tell us about likely trends in the crucial months that lie ahead for monetary policy?

Our research has shown that headline price inflation leads core price inflation, so the Governor of the Bank of England is correct in our view in not ignoring the influences that may be temporary but that could feed back into prices generally. The reason why policy makers like to concentrate on core inflation is because food and energy prices are judged to be erratic year to year and so monetary policy should ignore these and focus on inflation measures that pick up medium term price trends. But is that correct, can one really distinguish between short term and medium term price pressures so easily? The short answer appears to be no. The reason is that any price increase can impact inflation expectations – of consumers and companies and financial markets - and these expectations are crucial in determining what happens to actual price inflation in future.

…there is not such a thing as temporary, unless it does fall/rise quickly with no trend
Increases in energy and food prices hit consumer spending because they reduce incomes and so can depress ‘core’ prices artificially by reducing demand and so the price of other goods, but push up total inflation because they are included in it. Moreover, inflation may eventually leak from a higher inflation sector to others, as suppliers increase prices to the higher inflation sector or consumers demand more pay to compensate them for the higher prices they are paying (for the loss of income) and this then pushes up inflation generally. Therefore, inflation measures that exclude energy and food can be misleading for monetary policy, as they can result in interest rates being set too low, if the focus is on the wrong measure of inflation.

Analysis of UK price inflation by category shows that warning signs were missed...
A breakdown of inflation in the UK shows that this is not a minor point. Chart b shows that the relationship between the headline rate of inflation and the sub categories that make it up can be markedly different. Using the period since 1997 illustrates that some of these trends are not short term at all. Alcohol and tobacco prices, for example, typically rise faster than overall consumer price inflation. Food prices have been erratic, but since 2005 have been on an upward track. This means they should not be ignored and monetary policy based on measures that left them out would therefore be a mistake. The same goes for chart c, education spending, and chart d housing and fuels, reflecting the rise in energy prices, with the powerful upward effect that this then had on transport prices, which subsequently began to rise. This reiterates the linkages that exist between one price category, energy, which can be excluded from core, but has an important influence on other prices in the economy.

The price of services goods, principally hotels and restaurants have been above headline CPI inflation but have fallen back in recent months, see chart e, perhaps implying that we could soon see some slowdown in economic growth as this fall could be reflecting weakening consumer demand. Finally, chart f highlights that some prices are falling significantly, like communication and clothing and footwear. But this makes our point even more powerfully; these are categories that are affected by global price trends and had been pushed lower by low cost manufacturers from Asia - so suggesting that inflation was weaker than it actually was.

...and the rate is likely to be a higher peak than otherwise
Our analysis partly explains the error made by the MPC in the last few years - it saw a continued low rate of headline CPI inflation as suggested by the low core rate, see chart a, and a small gap with the headline rate. But what it missed was the rise in the headline rate that had begun to take off from early 2005 and culminated in the 3.1% rate seen in March this year. In that period, the MPC had been too complacent, seeing little pressure on core prices and ignoring the categories included in the overall rate that were rising rapidly because they were seen as temporary. Now, it needs to see a fall in core inflation as well as headline inflation, in order to be sure that price pressure is under control. Unfortunately, this implies that interest rates will likely rise to 5.75% within the next few months, something that might have been avoided had interest rates not been left too long at 4.5% in the misguided belief that headline price inflation would stay low.

Trevor Williams, Chief Economist

Weekly economic data preview

US interest rates to stay at 5.25%

• UK data this week are unlikely to change the market bias towards higher interest rates but could show mounting signs that housing market activity has peaked. House prices and mortgage lending data will be closely scrutinised for signs that higher mortgage rates are crimping new demand for borrowing. The CBI distributive trades survey on Wednesday will give an update on consumer spending in June, amidst signs of some slowing. Final Q1 gdp and current account figures, and consumer confidence, are due on Friday.

• US interest rates are forecast to stay unchanged on Thursday at 5.25%. The two-day Fed FOMC meeting will allow time for a more detailed study of the outlook for inflation and output growth which may lead to some changes in the accompanying statement. This may also determine the tone of the semi-annual testimony to Congress on the economy in July. Existing and new home sales data for April are due today and tomorrow. Core inflation data for May is due on Friday.

• M3 money supply data on Thursday and consumer prices on Friday will attract most attention in the euro zone for the latest developments on inflation and credit growth. Unemployment data from Germany and France is also due and may bolster confidence about stronger household consumption. Business and consumer confidence surveys are due on Friday. Interest rates in Norway are forecast to rise 0.25% to 4.50% on Wednesday.

News last week that the BoE nearly raised interest rates earlier this month has boosted speculation that the base rate will rise to 5.75% in July. Interest rate futures now infer an extremely high probability that rates will go up next month. Whilst we do not underestimate the risk of a rate increase, we still believe there is a chance the Bank may prefer a move in August. Our rationale is based on the fact that skipping the July meeting will allow the Bank to gather more inflation and growth data which should allow it to compile more precise inflation and growth projections. Moreover, aside from M4 money supply and BBA lending data, we do not believe that economic data released since the June meeting is of the caliber to tilt the balance in favour of higher rates just yet. However, the result of the June MPC minutes means a rate rise to 5.75% now seems inevitable. Economic data due over the course of this week is unlikely to swing the debate either way. Mortgage lending and approvals data from the BoE are due on Friday and could show new evidence that a slowdown in housing market activity is taking shape. The growth rate of lending secured on dwellings declined in March in April and will probably have fallen again in May as a result of higher mortgage rates following the May increase in base rates to 5.50%. Consumer confidence, final Q1 gdp and Q1 current account data will also be published on Friday. We expect gdp growth to be confirmed at 0.7% q/q and 2.9% y/y. Consumer confidence is forecast to have deteriorated to -4 in June from -2 in May, in line with the results of our latest Consumer Barometer (the June issue is due today). Respondents interviewed in our survey cited increased fears over job security linked to a sharp rise expectations that interest rates are headed higher. To what extent this may be translated into weakening consumer spending growth could be clarified in the monthly CBI distributive trades survey for June which will be published on Tuesday.

Expectations about the trajectory of US interest rates have been unusually volatile recently but speculation of a rate rise by year-end waned somewhat last week on concerns that the economy could still be adversely impacted from the downturn in residential construction and a combination of higher mortgage rates and tighter lending standards. Only two weeks ago Fed chairman Bernanke warned that the slowdown in the housing market could have a more protracted impact on the economy than originally predicted. With core inflation also showing signs of further moderation tthrough the second quarter, the stage looks set for US interest rates to stay unchanged on Thursday at 5.25%. Changes to the language in the accompanying FOMC statement are likely to be related to the rate of economic growth in the second quarter (stronger) and changes in core inflation. Whether the Fed decides to tinker with the view that core inflation remains 'somewhat elevated' and that inflation is still the 'predominant policy concern' is likely to determine the reaction in global currency and fixed income markets.

In the euro zone, focus will be on M3 money supply data on Thursday and CPI data on Friday for an update on inflation trends which could shape expectations about the likelihood and timing of a rate rise by the ECB after the summer. Despite a second decline this year for the German IFO survey in June, we believe interest rates are still on course to rise to 4.25% by year-end.

Kenneth Broux, Economist

Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE,
0207 626 - 1500

Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.


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