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Forex Research - Economics Weekly: The coming UK economic slowdown; Weekly economic data preview: UK producer prices, retail survey and MPC speakers in focus

Economics Weekly: The coming UK economic slowdown; Weekly economic data preview: UK producer prices, retail survey and MPC speakers in focus

Economics Weekly

The coming UK economic slowdown

Debate on interest rates still about how high they will go…
The current focus of financial market debate in the UK is on how high interest rates will have to rise in order to slow down economic growth and reduce inflation to the 2% target. To our mind, this debate is somewhat unbalanced, as the decision to raise Bank Rate to 5.75% in July is unlikely to have been unanimous, suggesting that rates cannot continue to be pushed higher without there being further economic evidence to support it. Some MPC members want to wait and see what effect the 5 increases since August last year have had or are having on the economy before taking any further action.

…but signs that the economy is slowing in the months ahead will change that
Debate should be shifting more to how much the interest rate increases so far will slow UK economic growth in 2008. It may seem as if the rate hikes since August are not having much impact but our analysis, based on an assessment of how the previous interest rate cycle impacted some key economic variables compared with how they are evolving in this cycle, suggest that a slowdown is already underway. This slowdown is affecting even those economic variables that the Monetary Policy Committee (MPC) cited recently as particularly worrisome, like house price inflation, mortgage and credit growth and consumer spending. In other words, there is a real risk of the MPC overdoing the rate increases if it persists in raising and does not pause for long enough to allow the slowdown to actually show up more clearly in economic data.

Mervyn King, the Governor of the Bank of England, has noted in recent speeches that the increases in base rates since August 2006 seem not to be impacting consumer spending or the housing market enough to warrant leaving rates on hold, but is this actually borne out by the evidence? Further, is this unusual at this stage of the interest rate rising cycle? The answer is no to both. But first of all, it is worth noting that the current tightening cycle started at a higher level to the last one. That began from a base rate of 3.5%; this one from 4.5%. Currently, base rates are 5.75%, a full percentage point above the last peak already, see chart a. Chart b shows a very interesting profile for consumer price inflation then compared with now. The MPC stopped raising interest rates in 2005 even though inflation was rising. Admittedly, price inflation was only 2%, but with hindsight it seems an extremely odd thing to have done and perhaps explains much of the subsequent acceleration in price inflation and money supply growth in the UK. The key point today however is that higher interest rates in this cycle are already leading to lower price inflation.

Our analysis of interest rate cycles suggests the economy is slowing as should be expected
Chart c shows that M4 money supply growth is accelerating (though no faster than when rates were first raised in August last year) and is faster than in the last rate cycle, though the suspicion has to be that this was partly caused by leaving rates too low then. However, the details of M4 do not support the view of faster growth in credit. Chart d shows that mortgage lending growth is falling, in line with previous periods of higher interest rates. Moreover, consumer credit, in chart e, is also trending lower. All in all, this supports the evidence shown in chart f that in this interest rate cycle net credit is already falling sharply and as one would expect 11 months into a phase of rising interest rates. This is at odds with MPC comments that there is no slowdown taking place in credit growth in the UK.

What of house price inflation? Chart g shows that house price inflation has accelerated since August last year but the current annual rate is well below that seen in the last interest rate cycle, which anyway indicates that it takes about 13 months before a rate rise begins to show up in slower house price inflation. This means that we should look for the evidence to come through from September’s figures onwards, not before. However, chart h shows that a good lead indicator of house price inflation also predicts that this will happen. Mortgage approvals are already falling, very much in line with the last interest rate cycle and supporting a slowdown in house price inflation in the months ahead. But what about the real economy, are there any signs of a slowdown? Chart I shows that retail sales growth is starting this tightening cycle much weaker than the last one, and is already trending lower, a little earlier than in 2003-2005. Indeed, on this basis, we believe that retailers will be really struggling by the end of the year with sales growth of around 2-2.5% a year or less. Finally, chart j shows that manufacturing output is also weakening. This is despite good survey results and two consecutive monthly increases. The point is that these increases still leave the annual rate of manufacturing growth lower than when interest rates started to rise in August 2006.

…Rates may have peaked but it will take some time before this slowdown eases wider concerns
Our analysis suggests that the UK economy is already responding to higher interest rates and slowing. This slowdown will show up more clearly in economic data in the next three months. At that stage, worries about pricing pressures, capacity utilisation and inflation expectations, will begin to fall to the wayside. However, the MPC may not announce that it is done raising rates even then (that could undermine some of their work by causing long term market rates to fall), but we believe that there is a good chance that base rates will peak at 5.75%. A rise to 6% is possible but is entirely dependent on the economic data.

Trevor Williams, Chief Economist

Weekly economic data preview

UK producer prices, retail survey and MPC speakers in focus

• A transition week in terms of global economic data and events will leave financial markets to mull over the impact of last week's rate rise by the Bank of England on the UK economy and reassess the outlook for interest rates through the rest of 2007. Strong economic data in the US last week will feed directly into the Fed's' semi-annual testimony on the economy to Congress next week, which may result in a revision to the 2007 and 2008 forecasts for gdp growth and inflation.

• Producer prices, global trade and the BRC retail sales monitor head up the economic calendar in the UK. The report last week of higher input and output prices in the manufacturing industry are forecast to be translated into faster PPI input and output price inflation in June. The global trade deficit is forecast to have narrowed slightly in May, but remains wide. The BRC retail sales monitor is likely to report a lacklustre month for turnover in June. MPC members Bean, Sentance and Blanchflower will deliver keynote speeches during the course of the week.

• Retail sales and consumer confidence data top the US release agenda this week. Lower car sales last month suggests retail sales may have been sluggish in June. Markets will concentrate on sales excluding petrol and cars for an update on levels of discretionary spending. A weaker dollar means the trade deficit is likely to have widened above the $60bn-mark in May. Consumer confidence is forecast to have stabilised in July. Fed chairman Bernanke will speak tomorrow on inflation.

• Industrial output data from Germany and France will be released in the euro zone. Final euro zone Q1 gdp data is also due and will incorporate profitability and productivity data by country and output category. French president Sarkozy is today expected to attend the Eurogoup meeting in Brussels where he may announce plans to delay public deficit and debt reduction plans. ECB president Trichet will testify to the European Parliament on Wednesday.

• Interest rates are forecast to stay on hold in Japan at 0.50% but rise 0.25% in Canada to 4.50%.

The increase in the UK base rate last week to 5.75% is likely to continue to weigh on financial markets this week as participants debate how the MPC voted and if discussions took place about interest rates having to rise even further to bring inflation under control. To this end, speeches by MPC members Bean, Sentance and Blanchlower this week will garner close scrutiny to understand how close interest rates are to their peak. Producer input and output prices are unlikely to soothe inflation concerns this morning. Higher input prices and strong demand imply that PPI inflation is likely to have accelerated in June. The June retail sales monitor from the British Retail Consortium will be published on Tuesday and is forecast to reveal weaker spending due to the inclement weather and rising household costs. Strong overseas demand for UK goods and services mean that the global trade deficit should have stabilised in May. Our forecast is for a small increase to £6.6bn from £6.3bn in April.

Although the preliminary estimate of Q2 gdp will not be released until later this month, data last week reaffirmed that the US economy probably strengthened in Q2. Buoyant conditions in manufacturing and services industries and stronger hiring trends in June underscored the very solid nature of economic fundamentals outside the residential property and construction sectors. The level of consumer spending at the end of Q2 will be under the spotlight this week, with reports due for June retail sales and July consumer confidence. A decline in new car sales in June suggests that headline retail sales could disappoint. Of more interest will be the core number, i.e. sales excluding cars and petrol. This is forecast to have increased in June for an 8th consecutive month. The preliminary estimate of July consumer confidence, compiled by the University of Michigan, is forecast to show steady consumer optimism. Markets will also keep a close eye on consumer inflation expectations.

Last week ECB president Trichet did not demur from market expectations that euro zone interest rates would rise in September or October. Mr Trichet is likely to be asked on the timing again on Wednesday when he testifies to the European Parliament. German and French industrial output are expected to have rebounded in May from a decline in April. In the case of Germany, a positive surprise could be on the cards on Monday after the report last Friday that new industry orders jumped 3.2% in May.

Canadian interest rates are forecast to rise 0.25% to 4.50% on Tuesday. Strong employment data last Friday will have reinforced inflation concerns at the Bank of Canada.
Kenneth Broux, Economist
LloydsTSB Corporate
Economic Research
10 Gresham Street
London, EC2V 7AE
020 7626 1500

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