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Forex News- Economics Weekly: Bias to tighten suggests higher UK interest rates; Weekly economic data preview: BoE rate hike very likely but no done deal

Economics Weekly

Bias to tighten suggests higher UK interest rates


Risk of a rate rise at the July MPC meeting... We have calculated a scorecard of UK economic data since the last Monetary Policy Committee (MPC) meeting to help to assess the likelihood of a change in policy at the July meeting. This scorecard, in table 1, suggests that the official short term interest rate is likely to rise this month. This is despite the narrow 5:4 vote to keep Bank Rate at 5.5% in June, and the perception that not much has changed in the economic and market data since the last meeting and the upcoming July meeting to warrant a rise in rates. So why a rise? The reason is, overall, data in the past month do suggest that economic conditions warrant a further hike. Moreover, our analysis of some key long term averages also supports a further small rise in rates, but suggests that the next move up is likely to be the peak.

…supported, just, by the balance of economic data released since June…
Table 1 shows our calculation of the key UK economic figures that have been released since the June 6/7 MPC meeting and the implied likely impact on interest rates, based on whether economic growth and inflation are likely to rise or fall as a result of the data. We have given a score of zero for an interest rate effect when there is little difference between the latest data release and the previous one; -1 for when the data are weaker and so the implied interest rate effect is negative for economic activity and inflation, and +1 for when the implied effect of the data change on interest rates is upward because it suggests faster economic growth and higher inflation. The final score is +2 for July’s MPC meeting, suggesting a bias to tighten. But the detail in table 1 also highlights why the vote on Thursday is unlikely to be unanimous.


…but this is not a foregone conclusion nor likely to beunanimous as the data are not unequivocal
Of the 22 series we look at, 6 are neutral for interest rates but, perhaps more importantly, 7 are suggesting lower interest rates. This adds up to 13 out of the 22, or 59% suggesting rates should either be left on hold or a reduction contemplated. This means that the July interest rate decision is not as clear cut as the financial markets are suggesting. Further, on this basis the analysis suggests that in unweighted terms it should be odds on that base rate will be left on hold at the July meeting. But there are 9 other indicators, the single biggest category, that suggest rates could be justifiably raised, and some would argue that they are the indicators that matter the most and so should have the highest weighting - these are market curves, retail sales, house prices, industrial activity expected by the CBI, mortgage approvals, gdp, and growth in money supply M4. Equally though, it could be argued that the 13 indicators that suggest base rates should be left on hold or lowered, like average earnings, the CBI distributive trades’ survey and mortgage lending should not be ignored either. But the overall score is probably about right, as consumer price inflation is still above target. In our opinion, other arguments than simply the month to month changes in economic variables have to be brought into the debate in order to make a more convincing case for a rate hike. It is these factors that make the likelihood of a further rise more likely rather than just the data released since the last MPC meeting.

There are other factors weighing in favour of one more rise in base rates
As mentioned above, UK economic growth is still above its long run average, arguing for higher rates on the basis that this is incompatible with stable inflation, especially when inflation itself is above the inflation target and its own long run average. Chart a (page 1) shows that economic growth is indeed above its long run average. This is important because, as chart b shows, the UK at the whole economy level does not have any spare capacity and actually has a positive output gap, which means that output is running ahead of its long run potential. This will lead to a build up of inflation pressure in the economy. Although this may not yet be apparent in labour markets, it is increasingly showing up in industrial capacity. This is also evident in the widening UK trade deficit, which is a sign of excess demand that cannot be met from domestic production and so represents suppressed inflation.

Chart c shows that the link between a positive output gap and higher inflation is very clear. Chart d also shows that this is being reflected in price inflation coming in well above the 10 year average, for consumer and retail price measures. Finally, chart e shows why this may be: real short term interest rates and bond yields have been below their 10 years average levels for a long time and thus have been contributing to strong economic activity, but allowed inflation to rise as the output gap became positive. The good news is that real interest rates are now rising so inflation should fall back, but this will only happen if economic growth gradually falls below the long run average and the output gap therefore falls from positive to negative. It is these broader arguments that really support a further rise in base rates at the July meeting and, with that background, suggests that if there is no rise in July then there will likely be one in August. However, the closeness of the balance of economic data this month suggests that any rise above 5.75% will have to be driven by worsening inflation and faster growth to convince a majority on the MPC. Hence, it also looks like UK base rates are close to a peak in this current cycle and 6% looks unnecessary.
Trevor Williams, Chief Economist

Weekly economic data preview

BoE rate hike very likely but no done deal


• The Bank of England MPC is widely expected to increase Bank rate by 0.25% to 5.75% this week, the fifth such hike since last August. However, given the clear split on the committee, the decision is unlikely to be unanimous and the small risk of a vote to keep rates unchanged should not be ruled out. The difference in opinion highlights that we are nearing the peak in interest rates in this cycle. While we acknowledge the risk that Bank rate may rise to 6%, our central view is a peak of 5.75%.

• Despite data before the MPC decision that could raise doubts about a rise, financial markets are still likely to price in two hikes to 6% this year. The price components of the PMI surveys of manufacturing and services activity will attract strong attention, because the MPC have said it is focused on this area. However, the most important release this week is likely to be the press statement published if Bank Rate is hiked, which will be dissected for any clues about further tightening ahead.

• The main economic data highlight of the week is the US labour market report on Friday. New nonfarm payrolls have averaged 148,000 in the past six months, but our view is for 120,000 new jobs in June. The unemployment rate is forecast to remain at 4.5% - well below the long-term average – as growth is still strong. The ISM surveys are forecast to show economic activity remained robust in June. US financial markets are closed for Independence day on Wednesday.

• Economic data from the euro zone this week should underline the prospect of at least one further hike in interest rates this year. The PMI surveys should show economic activity remains robust as EU-13 unemployment continues to fall. However, the ECB is set to keep interest rates unchanged at 4% on Thursday and president Trichet is very likely to remain guarded about the timing of the next hike, but we expect the repo rate to rise to 4.25% in either September or October.

• The Reserve bank of Australia is forecast to leave interest rates steady at 6.25% early on Wednesday.

Financial markets have already fully priced in a hike in UK base rate to 5.75% on Thursday. While the probability does appear high, it is worth highlighting that the MPC voted in favour of unchanged rates in June and individual member testimonies to a Treasury select committee last week showed a marked difference of opinion on the need for higher rates. It is therefore unlikely to be a unanimous decision on Thursday and a surprise should not entirely be ruled out. We expect Bank rate to be raised to 5.75%. Our long-standing view has been that 5.5% could prove the peak in interest rates in this cycle but that 5.75% was equally likely, if the BoE took too long in raising rates. This has turned out to be the case, and inflation expectations have risen as a result and consumer inflation expectations, as evidenced in our own LTSB Consumer barometer survey and the BoE NOP survey, are at or close to record highs. We were looking for a trigger to prompt the timing of the next hike, but rather than particularly strong economic data, this has proved to be the surprisingly close MPC decision last month and the related growing weight of market expectation of a rate hike in the shadow of some hawkish comments from governor King and the other 3 members of the MPC looking for a hike. We believe that despite no overwhelmingly strong justification from economic releases since the June MPC meeting, the data overall will have been strong enough to persuade at least one member from the majoritycamp that voted to keep Bank rate on hold in June to change their vote. Moreover, the main reasoning could be the view that a hike now could result in a lower peak later and that it would not surprise the financial markets, both key considerations mentioned in the June MPC meeting minutes.

US data are likely to show that growth in Q2 is solid. Both of the ISM surveys should show robust activity, but the headline indices may have eased back slightly in June from recent highs. The eagerly awaited June payrolls report should show jobs growth has stayed firm and that the tight labour market still poses an key upside risk to inflation, especially if gdp growth picks up. The ADP report on Thursday should show that employment rose in June

ECB president Trichet is unlikely to drop any hints about the timing of the next hike in euro zone interest rates at the press conference on Thursday but his view of recent strong data may raise expectations of a rise in September. Strong PMIs and another fall in EU-13 unemployment will only underline the prospect of higher interest rates.
Jeavon Lolay, Senior Economist

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