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Monday September 3, 2007 - 13:34:50 GMT
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Economics Weekly - UK economic volatility; Weekly economic data preview - BoE and ECB expected to keep interest rates on hold...for now

Economics Weekly  3 September 2007


UK economic volatility has fallen sharply - due to labour market improvement


Lower volatility has boosted UK economic growth

In the constant stream of bad news from the credit markets, there has been a lack of attention placed on some very important developments in the UK economy. Key amongst these has been a fall in UK wage inflation, which has been puzzling for some observers as it has been accompanied by lower unemployment. This fall in unemployment has taken the rate down to its lowest levels since the early 1970s. But we think the answer is quite simple: lower volatility, in economic growth and in wage inflation has meant that companies have been much more willing to hold on to staff and at the same time employees are willing to accept lower wage rises because they are more confident about keeping their jobs. The latter is especially relevant because low and stable price inflation means that the real (or inflation adjusted) spending power of those in employment is still strong, even if wage inflation moderates a little. This situation seems to have turned into a virtuous cycle, with low wages encouraging employment growth and as a result encouraging people to keep wage demands moderate and to continue to spend in the shops and on services, so boosting economic growth.


Evidence of lower volatility is abundant…

Volatility in UK growth and inflation has fallen sharply in the last decade. We have calculated the standard deviation of UK economic growth and economy-wide inflation over the last 40 years. We also looked at the last 10 years and the 7 years from 2001 to the second quarter of 2007. These areshown in table 1. Quite clearly, the standard deviation of economic growth has fallen sharply from 2.1% to just 0.7% and 0.6% in the last 7 years. In the same period from 1968 to 2007, the standard deviation of the economy wide inflation rate (gdp deflator) has fallen from 5.7% to 0.7%, with a modest rise to 0.8% from 2001 to date.


…and seems to be related to a better trade off between wages and unemployment…

What has led to this fall in volatility? A number of reasons spring to mind, better fiscal and monetary policy and lower global inflation, but, within the UK, chart b shows that the main reason is lower wage inflation, which has helped lead to lower unemployment. Lower unemployment in turn has helped promote faster economic growth as the so called NAIRU – non accelerating inflation rate of unemployment, in economist jargon – has fallen very sharply. In other words there is now the best trade off between wage inflation and unemployment since the late 1960s, see chart b. This has allowed interest rates to stay much lower than at any time since the 1960s. It is this benign combination that has given rise to such great stability in the economy and the best growth performance in terms of length and pace since the 1950s. However, this good news for the economy has not come without some less benign consequences.


...but some of the consequences of low inflation, low interest rates and added economic stability may not be benign though it does mean rates may have peaked

Lower volatility seems to have helped to fan the increased risk taking that has occurred in credit markets in the last five years, because lower inflation has allowed sharply lower interest rates. Lower price inflation and lower interest rates reduced the return on conventional assets, which encouraged some investors to go into riskier assets that offered higher yields with seemingly low risk. Continued economic growth has boosted liquidity, which meant that there was more funds available to invest. This increase in liquidity, from income as employment rose and from companies as profits rose, resulted in lower returns, also driving down investment returns. But low volatility does not mean that interest rates remain very low in absolute terms forever, just low variation from year to year, so as the period of exceptional low interest rates has ended with higher inflation and increased defaults, the risk of holding some assets has risen. A significant number of investors seem to have been caught out by the subsequent repricing of risk.


Nevertheless, the broader picture is that the much improved performance of UK wage inflation (down to a 3.3% annual rate in June this year) means that official short term interest rates in the UK may not have to rise from the current rate of 5.75%. In our opinion, they have peaked. Any rise from current levels will simply lead to unnecessarily lower economic growth and inflation falling to well below the 2% target. From an investor perspective, improved (i.e. lower) volatility should mean an increase in equity and bond market investment, as it is the result of lower inflation, which implies that real returns have risen and the risk premium should be lowered. This is exactly what seems to have occurred, with the pound appreciating and an increase in its holding as a currency reserve around the world alongside an increase in inward net investment in the UK company sector.


Trevor Williams, Chief Economist


Weekly economic data preview


BoE and ECB expected to keep interest rates on hold...for now


The focus this week will be on interest rate decisions in the UK and euro zone on Thursday. While we expect both the BoE and ECB to maintain interest rates, at 5.75% and 4% respectively, the risk of a hike - if only from the ECB, should not be discounted. Financial markets will also be alert to any policy action from the Fed to help ease the continuing dislocation in money markets. The US labour market report is the main data highlight on Friday. We look for 115,000 new non-farm jobs in August, with the unemployment rate remaining steady at 4.6%.


• The recent pronounced volatility in global financial markets has reduced the probability of an increase in base rates at the Bank of England MPC meeting this week. Although interest rate futures continue to predict a hike to 6% (levels may be partly distorted by current elevated levels of short-term money market rates), the decision to maintain interest rates at 5.75% last month was unanimous and the minutes of the meeting also noted that most members of the MPC had no firm view on whether interest rates would need to rise further, and this was before the fall in inflation to 1.9% in July. We remain of the view that interest rates have peaked at 5.75%, with the prospect of two cuts next year on slowing growth and inflation. However, given the current resilence of growth to the five interest rate hikes sanctioned since last August, the risk of a further rise cannot be discounted until the slowdown becomes clearer in the data.


• The ECB interest rate decision on Thursday has more uncertainty attached than usual. Although ECB president Trichet strongly signalled that interest rates could rise to 4.25% at the August meeting press conference, his most recent comments - highlighting no pre-commitment to do anything - and continuing restrictive money market rates (despite significant addditional liquidity) has raised speculation that interest rates may be maintained at 4% on Thursday. However, there is still the small risk of a hike, and we also believe that given the recent strength of economic data, a hike to 4.25% is more a question of timing rather than need and so the ECB will look for the first realistic opportunity to reach this level. The press conference will draw strong attention regardless of the decision.


• The main economic release this week is the US labour market report. We expect this to underline that economic conditions in the US remain favourable, questioning the logic of the need for a cut in the official fed funds rate on September 18, unless conditions deteriorate further in the credit markets. Fed chairman Bernanke said last Friday that he 'stands ready for more actions to provide liquidity' and so further supplemental policy measures are possible ahead of the next FOMC meeting and even this week but this does not necessarily mean lower rates. Ahead of the US labour market report, the ADP employment report and the ISM manufacturing and services surveys should provide some clues about Friday's payrolls outcome and about economic prospects in Q3.


• Manufacturing and services PMIs in the UK and euro zone this week are expected to show continued strong activity, if at a slower pace than in July, reflecting firm domestic and external demand. However, although the official UK industrial output data, on Thursday, may show the fifth consecutive monthly rise in production in July, it will still stand only around 1% higher than the same time last year. In contrast, German industrial output in July is forecast to remain close to 5% higher than last year, underpinned by double digit growth in factory orders and rising exports to Asia.


Jeavon Lolay, Senior 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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