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Economics Weekly: Slower growth to lead to UK rate cuts; Weekly economic data preview: BoE and US Fed publish minutes of their last interest rate setting meetings

Economics Weekly 19 November 2007

Slower growth to lead to UK rate cuts

Interest rate sentiment has shifted in the UK in the past month following the release of November’s Quarterly Inflation Report (QIR) from the Bank of England. It was made very clear in the report that the next move in UK official short term interest rates is downwards. This in spite of 3.3% annual growth in Q3 2007 and the first rise in annual price inflation sinceMarch, which took the rate to 2.1% for October and just above the 2% target from the 1.8% rate recorded in August and September. Of course, the QIR to some extent validated a view amongst the financial markets that the next move in UK rates was down, but the report finally removed the doubts held by some.

Many argue that why should the Bank of England wait, why not just cut interest rates straight away?
One MPC member, David Blanchflower, has clearly taken this approach and voted for a 0.25% rate cut at the November meeting, where the decision was 8:1 to leave Bank rate at 5.75%. A tightening of credit standards, lower retail sales and slower growth in house prices are cited as evidence in favour of immediate rate cuts. But in the briefing that accompanied the QIR, the Governor, Mervyn King, reiterated that there were still worries about the elevated ability of companies to pass on increases in their costs to customers, high expectations held by UK households about inflation trends and higher oil and commodity prices as factors that should lead the MPC to wait for further evidence before acting. Indeed, the Governor said that the timing of the rate cut was ‘data dependent’. In particular, on the actuality of the economy slowing down from its recent fast pace.

What the latest Inflation Report said
The report highlighted that the risks to growth are to the downside, while those to inflation are more balanced. However, it is worth noting that the profile for inflation in the November report is higher for 2008 than in the August report and the committee consider the uncertainties surrounding the medium-term outlook as higher than in August as well. Reflecting this uncertainty, we believe the Bank of England will continue to proceed cautiously and look for clearer signs of slower economic growth and stable inflation before deciding to cut interest rates.

Inflation to ease to target, economic growth to slow
The latest BoE forecasts show that UK economic growth slows quite sharply next year, assuming Bank rate follows market expectations, troughing at around 2% in Q2 2008, although then recovering towards 3% at the end of the two-year horizon in 2009. The slowdown is based on the impact of the previous hikes in Bank rate, tighter credit conditions and heightened uncertainty, while the recovery is supported by lower interest rates and weaker sterling. Both the pace of the slowdown and extent of the consequent rebound in growth are slightly sharper than that predicted in the August Inflation Report. Our forecasts show a similar profile, with UK growth slowing to 2.3% in 2008, from around 3.2% this year, before picking up to 2.8% in 2009.

So what sort of economic data will the MPC be looking at before deciding to cut rates?
We have put together a series of charts that look at a range of UK economic indicators in relation to the last interest rate cycle and the current one to judge the pace of the adjustment of some key economic variables to higher interest rates since August of last year. Some of the data support the argument for a rate cut; others support the argument for a hold. On balance, our take on the figures is that interest rates will not be cut at the December MPC meeting but at the meeting in February 2008, though an earlier move cannot be entirely ruled out.

Rate rises since August slowing economy
It is increasingly becoming clear that the 125 basis point of tightening since August last year is finally taking effect, but the impact is not yet clear cut. Chart a shows that manufacturing output growth is falling and is in line with the slowdown that occurred in the last interest rate tightening phase of 2003-2005. House price inflation is finally slowing sharply, chart b, with the path it is taking bang in line with the last rate cycle, some 15 months after the initial rate rise. Retail sales growth is now weakening, and was down by 0.1% in November. However, this still leaves the annual rate a little stronger than in the last rate cycle, see chart c. Other evidence is that PMI surveys are lower, both for services and manufacturing; the CBI reported that order books were sharply lower in October and the British Retail Sales Consortium (BRC) reported sales are down, with Gfk consumer confidence also showing some fall back.

But as chart d shows, inflation rose in October, and though down on the year is high. Unemployment fell further in October, by 9,900, but tracks the experience of the 2003-2005 phase, see chart e. Worryingly, chart f shows average earnings growth picking up, but it is still very low and below the experience of the previous monetary tightening cycle. Despite a squeeze on incomes, mortgage lending is still strong, see chart g. However, chart h shows that mortgage approvals are now falling and this will reduce the value of mortgage loans in the months ahead. Moreover, chart i is indicating that consumer credit has also weakened sharply; though up off its lows in October. But money supply growth, chart j, remains stubbornly strong. This will cause the MPC to pause as it implies strong asset price inflation.

In summary, we believe that there remains enough to worry the MPC for it to leave rates at 5.75% in December, but a cut in February is odds on. Further cuts in 2008 are likely, possibly down to 5% by the end of the year, if the economy slows and leads wage inflation to fall anew.

Trevor Williams, Chief Economist

Weekly economic data preview

BoE and US Fed publish minutes of their last interest rate setting meetings

The US market is closed for Thanksgiving on Thursday/ Friday and this week is generally far quieter for economic data. But minutes of the US Fed and the BoE meetings on 7/8 November and 31st October, respectively, feature, which are expected to highlight the content of discussions on appropriate levels of interest rates. Markets are now poised for a series of interest rate cuts by the Bank of England, so this week's data will be closely watched for signs of economic slowdown necessary to justify cuts in interest rates. US housing market data may continue to point to further weakness, fuelling the debate over whether or not the Fed will cut rates further this year. Fears that the strong euro and the credit crisis is hitting the eurozone economies may be dashed as flash EU-13 manufacturing and services PMIs for November may show the economy growing above the key level of 50, indicating expansion and leaving the door open for higher interest rates early next year.

• On Wednesday, the minutes of the last MPC meeting are likely to show an 8-1 voting pattern in favour of keeping rates unchanged at 5.75%. The leading dove, David Blanchflower, may well have again been the only dissenter, voting to cut rates immediately, rather than waiting until the economy shows clearer signs of slowdown. Analysts will glean the content of the discussion for any other indication that members are more seriously concerned about growth or, indeed, are opposed to cuts.

• Preliminary UK monetary data for October is published on Monday and should confirm that M4 money supply growth is accelerating, rising 13.1% annually, compared with 12.8% in September. M4 sterling lending may weaken for the second consecutive month to a rise of £21bn in from £23.7bn in September and £26-27bn a month in July/ August, as borrowers tighten their belts and shore up flagging savings. Building Society mortgage approvals are also published giving an early indication of the health of the wider housing market in October. Public finance data may show the PSNCR at -£7bn, lowering the cumulative deficit to £6.2bn from $13.2bn in September. The CBI industrial trends survey may fall to -8 in November from -6 in October, the weakest outcome since January, perhaps due to sterling's strength. The details of the survey will highlight export performance as well as future expectations for output and prices. On Friday, UK Q3 gdp is likely to be confirmed at 0.8% on the quarter and 3.3% on the year.

• The current situation in the US construction industry and housing market will fix attention on Tuesday. Housing starts may decline to 1.18m in October from 1.19m in September, while building permits may fall to 1.21m from 1.26m in September. Also, at 19:00 the Fed publishes minutes of the last FOMC meeting, which should confirm the view that upside risks to inflation are now balanced by downside risks to growth. A fairly high number of initial jobless claims may be published again on Wednesday, suggesting that this month's NFP jobs number may be below last month's level of 166,000. Also Wednesday, University of Michigan consumer confidence may be confirmed around the 75 level, the lowest since October 2005.

• Market participants may be on the lookout for signs of strength in European data, thus supporting the case for higher interest rates. EU-13 industrial orders in September may strengthen despite exporters' concern over the strong euro. The key data this week is published on Friday - flash November PMIs for manufacturing and services. Manufacturing confidence may rise to a balance of 55.5 from 51.5 in October. Service firms' confidence could fall a touch to 55.5 from 55.8 in October.

• In the wake of last week's disappointing manufacturing release, Canada's consumer price and retail sales data on Tuesday and Wednesday, respectively, will attract interest. The figures are expected to be strong, supporting calls for higher rates.

Nichola James, Senior Economist

Economic Research,
Lloyds TSB Corporate
Markets,
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