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Monday July 16, 2007 - 11:34:12 GMT
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Economics Weekly: UK interest rates scenarios show threat to the economy; Weekly economic data preview: Focus on UK CPI and GDP, BoE MPC minutes and the Fed

Economics Weekly

UK interest rates scenarios show threat to the economy

Earlier in the year when it was apparent to us that UK interest rates would get close to 6%, we ran a series of scenarios to gauge what the impact of rates at these levels and higher would do to economic growth. With base rates currently at 5.75% and the financial markets expecting them to reach 6%, and possibly 6.25% before the end of the year, we thought it might be instructive to repeat the exercise. The results of a scenario of 6.25% base rates by the end of September and one of 6.75% by the end of December 2007 compared with our base case of rates peaking at 5.75% and falling in 2008 are shown in the charts.

Economy more vulnerable to interest rate increases than current data indicate
In the last few months, consensus estimates of UK economic growth for 2007 have been revised higher after a string of better than expected economic data. But this is misleading for prospects in 2008, as the economy has had little time to be impacted by the five increases in interest rates since August 2006. Our view is that these negative effects will be reflected in economic data in the next few months, and increasingly strongly. In this process, consumer activity will be hardest hit, with retail sales, car registrations and credit card borrowing weakening sharply. As this progresses the housing sector and company investment will also begin to weaken. But as this unfolds, in the interim the risk is that interest rates are raised further. For this reason, and to get an update of the upside risks to the economy of higher interest rates in light of the current uncertainty, we have run two scenarios. The first is of 6.25% base rates, just ½% higher than the current rate and expected by some in the financial markets but not yet fully reflected in forward rates. The second is of base rates rising to 6.75%, a full 1% above current levels and clearly an extreme case, though one that highlights the risks to the UK economy of over tightening. Each of the scenarios are compared alongside the base case (of unchanged interest rates of 5.75%), in terms of the economic impact on a number of key economic variables.

6.25% still the trigger for sub 2% economic growth in 2008
The big picture that the scenarios show is that 6.25% base rates still remains the key pivotal point for economic growth in the UK. Interest rates at this level will result in economic growth of around 1¾% in 2008, well below the 45 year average of 2.5% and the 10 year average of 2.8%. Price inflation on the measure used for the MPC’s target will fall to well below 2% in 2009 and could hit 1.1% in the final quarter of that year. This undershoot is clearly not justified by current economic growth conditions, which, whilst firm, are not at boom levels and inflation at 2.5% in the year to May is falling towards the 2% target. But the scenarios highlight that forecasts of 6.75% base rates, touted occasionally, are well wide of the mark, as that they would lead to recession conditions in the UK. Consumers would sharply raise their saving rate, spending would drop to under 0.5% a year, hitting the housing market hard and leading to recession in manufacturing and severe cut backs in investment spending, see charts.

The charts highlight that consumer spending takes the biggest hit but companies will also be affected
Looking at the charts, the evolution of the economic impact is quite clear. Chart a shows that economic growth is expected to average 2.3% next year on the base case; if base rates are raised to 6.25% growth drops to 1.8% and if rates are raised to 6.75% economic growth falls even further to just 1.4%. Chart b to g shows why this happens. Weak economic growth leads to a sharp rise in unemployment, chart b, this in turn leads consumers to cut back on spending on cars, chart c, and cut borrowing, chart d, which impacts the housing market severely, chart e, and so lowers spending on retail sales and consumer spending, charts f and g. This is the mechanism that also operates in our base case but is amplified the higher interest rates are raised. Although consumer spending will bear the brunt of the shift to slower growth, the corporate sector (charts h and i) is not unscathed and a sharp fall in profits will lead to cuts in investment spending, which then also reduces gdp growth and feeds back to consumers via higher unemployment. But it is the effect of interest rates on inflation that ultimately matters for policy makers and chart j shows that the impact of 6% plus interest rates is quite dramatic. Our base case leads to inflation being on or about the MPC target in 2 years’ time. But 6.25% base rates leads to a CPI rate of 1.7% and 6.75% base rates to 1.5% in 2009, both well under the 2% target and as equally poor an outcome for the MPC as overshooting by that margin. This suggests that the MPC must now pause and see what effects the rate rises so far are having; the scenarios show that the risks of over-tightening is unnecessarily lost output and an undershoot of the inflation target.

Trevor Williams, Chief Economist

Weekly economic data preview

Focus on UK CPI and GDP, BoE MPC minutes and the Fed

• A raft of UK economic data and the minutes of the July 4/5 BoE MPC meeting will be dissected to help understand the likelihood and timing of 6.0% base rates. The preliminary estimate of Q2 gdp is forecast to show steady growth of 0.7% q/q. CPI inflation is forecast to have slowed to 2.3% in June and the ILO unemployment rate is forecast to have stabilised at 5.5% in May. Retail sales are forecast to have increased 0.3% in June. We expect the MPC minutes on Wednesday to show that three members opposed the July rate rise to 5.75%. A 6-3 vote and subdued inflation data could ease fears about significantly higher interest rates.

• The semiannual testimony of Fed chairman Bernanke on the US economy dominates the US calendar. With economic growth strengthening in Q2, the Fed is still likely to be confident that inflation will moderate later this year and in 2008. Its updated projections for gdp growth and inflation will be published on Wednesday and will be digested carefully. Producer and consumer prices, capital flows and housing data are all due during the course of the week and may impact expectations for interest rates and the dollar.

• The highlight of a quiet week in the euro zone is the release of the German ZEW survey for July on Tuesday. Financial markets' sentiment is forecast to have rebounded from June after a very upbeat report on new industry orders for May and a record high for German equities last week.

Niggling uncertainty and suspense of how the Bank of England MPC voted for higher interest rates in July will come to an end on Wednesday when the minutes of the meeting are published. A unanimous vote for higher rates would come as a major surprise and would support the view that interest rates will rise to 6.0% soon. Details of the discussions that took place between the policy members are likely to receive considerable attention. One of the questions that preoccupies markets is the MPC's view of the fact that futures markets currently still price in a rise in rates to 6.0%. A swathe of economic data is likely to help participants to fine tune their assessment about the most likely trajectory for monetary policy in the second half of the year. The BoE justified this month's rate rise by referring to low levels of spare capacity and buoyant growth in money supply. This week's releases of labour market data, Q2 gdp and M4 money supply will help the BoE to form an opinion of where the economy stands and whether the 125bp increase in rates since last year will be enough to damp inflation. We expect the MPC minutes to show a 6-3 split. Consumer prices will be released on Tuesday and we forecast a decline in CPI inflation to a 13-month low of 2.3% in June from 2.5% in May thanks to seasonal discounting in retail and cheaper seasonal food prices. RPI inflation is forecast to have drifted back below the 4.0% mark to 3.9%. Labour market data on Wednesday is forecast to show a 9th consecutive drop in the claimant count rate in June, supported by solid activity in the manufacturing and services industries. Our forecast of a 7,000 decrease would take the total claimant count to 872,000, the lowest since August 2005. Wage inflation has slowed gradually after hitting a 3-year high of 4.6% in March and we expect this downward trend to have continued to 3.6% in May. Retail sales, M4 money supply data and public finances are due on Thursday. A more upbeat than expected June retail sales monitor from the British Retail Consortium suggests that business on the high street is unlikely to have been affected too much by the inclement weather in June. The BRC reported that early discounting brought out shoppers in respectable numbers last month. We have pencilled in a 0.3% sales increase. But this would lower the annual growth rate to 3.5% from 3.9% in May. The preliminary estimate for Q2 gdp is due on Friday, and we expect 0.7% growth from Q1 but a drop in the annual rate to 2.8% from 3.0% in Q1. This would mark a 6th consecutive quarter of = above trend growth and could keep markets still betting on a further rise in the cost of borrowing.

The positive dataflow from the US showed a minor blip in the form of disappointing June retail sales last week but this should not detract too much from Q2 gdp growth, which is expected to average roughly 3.5% vs 0.7% in Q1. With companies like GE presenting a positive outlook for the coming quarter and underlying dynamics in the US economy outside housing and residential construction looking solid, the question is will the Fed make any adjustments to its 2007 and 2008 projections for economic growth and inflation? The testimony of chairman Bernanke will assume a central role on Wednesday and could impact financial markets worldwide as participants review their expectations for US interest rates. Core inflation and housing data for June and the latest Fed FOMC minutes will also draw close scrutiny.

In the euro zone, the German ZEW survey of economic sentiment is forecast to have rebounded in July, underpinned by gains for equities last week and a positive assessment of new industry orders in May.

Kenneth Broux, Economist
LloydsTSB Corporate
Economic Research
10 Gresham Street
London, EC2V 7AE
020 7626 1500

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