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Forex Market News - Economics Weekly: Where will UK base rates end 2007? Weekly economic data preview: Busy week for data, headed up by the US NFP report on Friday
Economics Weekly:
Where will UK base rates end 2007?
After the increase in UK base rates to 5.5% in May, the Quarterly Inflation Report and the minutes of the May Monetary Policy Committee (MPC) meeting, the financial markets are now looking for them to hit 6% or so by the end of the year. This is very aggressive compared with economic growth of 2.9% for Q1 2007 and inflation falling back to 2.8% in April. Is this view justified and where are base rates likely to be at end 2007?
MPC may have left it too late and now has to be more aggressive on interest rates
Our long-standing view has been that 5.5% could be the peak in UK interest rates, but only if this level was reached quickly enough by the MPC to squash consumer and market inflation expectations, if not then 5.75% was very likely and possibly higher. This, unfortunately, appears to be the current situation. The committee said in the May minutes that, ‘..should the economy continue to develop broadly in line with the central expectation, Bank Rate could be raised further as necessary.’ This suggests that even if economic growth is as the MPC expects (they are looking for 3% this year) and inflation falls back as predicted, base rates may still rise. Therefore, at least one further rate rise in the months ahead appears odds on, but there has to be a trigger. We look at some economic variables that could act as triggers, but some also imply that a rate rise is not a done deal, especially if CPI inflation does fall back close to 2%.
May MPC minutes were hawkish
We think it is telling that the minutes show the committee felt that a strong case for a larger hike could only have been made if they were confident about the need for another rise soon, implying more concern with medium term trends than short term ones. We would interpret that as suggesting a June rise is unlikely but July and August might be very possible, depending on growth and inflation trends. This means particular focus should be placed on economic data released over the months ahead. Most obvious are money supply, indicators of company pricing power (business surveys and producer price data), wage and price inflation and retail sales and manufacturing output.
Inflation expectations have risen and some indicators are showing economy operating above trend
Inflation expectations, chart a, held by financial markets are well above the trend of the last 10 years. It will take evidence that actual inflation is falling as well as tough action on interest rates to bring these back down to the average. Since inflation expectations are critical in keeping actual inflation down, and the Bank of England has said this many times, interest rates are likely to remain higher for longer in order to bring down these expectations. Consumer price expectations – measured in a survey for the MPC and by us here at Lloyds TSB Corporate Markets – are also above their series averages, supporting a tighter monetary policy stance. Chart d shows that company pricing intentions, as shown by a CBI survey of firms expecting to raise output prices, is at its highest level since 2004 and well above the 10 year average. This inflationary backdrop is underpinned by the fact that actual price inflation is well above the 10 year average rate and, though now coming off this peak, clearly has much further to go before falling back to the 2% target.
A generally stronger growth background is also consistent with higher actual inflation and rising inflation expectations. Chart f shows that the UK economy has a positive output gap, i.e. is operating above its long run capacity. (This partly explains the slide into wider trade and current account deficits in the last year). And chart g highlights that even manufacturing firms are seeing the smallest spare capacity since 1997, and operating well below the 10 year average. But average earnings growth remains well behaved see chart h, and the annual rise is only just above the 10 year average, with some signs that it could even be slipping back. UK economic growth is not expanding much above the 10 year average of 2.8%, at 2.9% in Q1 2007. This suggests little reason for any further aggressive tightening of interest rates from current levels. Chart j shows that official short term interest rates are above the 10 year average, but this has only recently occurred. It could mean they have further to rise or that they remain at current levels for longer.
A rate rise is not a done deal unless strong data flow supports it
Overall, we believe that it is a close call whether interest rates will rise any further at all. Whilst it is true that M4 money supply growth accelerated to 13.3% in April, data from the British Bankers’ Association suggest that past interest rate rises are leading to some cooling in consumer lending. Q1 gdp growth was unrevised at 0.7% (though the annual rate was revised up to 2.9%= from 2.8%) and we expect growth to moderate slightly in the second half of the year and CPI inflation to slow towards 2% by end-December, although progress towards this may be uneven. This is sufficient for us to see a good chance that the MPC may, in fact, leave interest rates at 5.5% for the remainder of the year. However, we acknowledge a rise 5.75% is very likely, but talk of rises to 6% and beyond seems to be unjustified at present, unless growth suddenly accelerates, but there is no evidence that this will happen. If inflation slows more sharply than expected or growth eases back, a rate rise is unlikely, despite the upside risks.
Trevor Williams, Chief Economist
Weekly economic data preview
Busy week for data, headed up by the US NFP report on Friday
• Global bond prices remain on the retreat and the dollar has regained some of its poise after a recent set of stronger than expected US data. Financial markets are no longer confident of a cut in US interest in 2007 and data this week could see expectations of a rise. We remain of the view that the Fed will not change interest rates this year, with the risk of a hike now slightly larger than that of a cut. The Fed publishes the minutes of the May 9th FOMC meeting on Wednesday.
• The US labour market report provides the data highlight of the week and promises another nervy Friday. Jobs growth last month fell to the lowest in over two years, at 88,000, and the unemployment rate also edged up a touch to 4.5%. However, a rebound is forecast in May, after a solid set of recent initial claims figures. We look for 150,000 new payrolls, just below the previous six month average of 156,500. The second estimate of Q1 2007 gdp will also draw significant attention on Thursday. We forecast only a modest downward revision to growth, and would focus more on data for Q2, as there were so many one-off adjustments in Q1 that we are unwinding in Q2.
• The minutes of the May BoE MPC meeting last week showed a unanimous vote to raise interest rates by 0.25% and some discussion of a possibly larger increase. UK data this week is unlikely to change the prevailing market view that interest rates will rise again in 2007, but could question the need for them to rise to 6%. The main focus will be on the April lending data on Thursday and in particular mortgage approvals, to gauge the health of the housing market in the face of the previous hikes. We look for only a modest fall to 110,000, but extending the declining trend to three months.
• Data from the euro zone this week are expected to support the outlook for higher interest rates. The news from Germany has been particularly robust of late and this should be reflected in rising retail sales, falling unemployment and a stronger manufacturing PMI this week. The 'flash' estimate on Thursday may show EU-13 CPI finally climbed back to 2% in May for the first time since August.
Global bond yields have been heading higher in recent weeks (see chart below), as financial markets scaled back their expectations of a cut in US interest rates in 2007 and also raised bets of higher interest rates in the euro zone, UK and Japan. Further gains in global equity markets, with the S&P 500 notably touching a record high this week, have also added to bearish sentiment. Economic figures from the US are showing signs that a recovery in growth could be underway, although the latest data from the housing market were mixed, with April existing home sales data last Friday disappointing expectations and countering the solid rise seen in new home sales. There clearly remains a risk that the softness in the housing market could weigh on the wider economy for some quarters to come. However, there are also reasons to be confident of a bounce-back, with employment still rising strongly and signs that business investment is recovering. Also, Q1 gdp growth is likely to be revised lower on Thursday, reflecting a disappointing set of trade figures and lower inventories. This suggests growth in Q2 could turn out even stronger, especially starting from a lower base. However, the key will remain the performance of consumer spending, which has held up well so far. This is why the labour market report on Friday is so crucial. We expect 150,000 new payrolls in May, up from 88,000 last month. The unemployment rate is also important, as is earnings growth, both of which are already at buoyant levels. Adding further colour to the picture should be releases of consumer confidence on Tuesday and personal spending and incomes on Friday. The May Chicago PMI and manufacturing ISM should show the pace of industrial activity has picked up. It could be a volatile week for financial markets, with the May Fed meeting minutes also due on Wednesday.
Economic news from the UK is limited and could weigh on sterling this week. Financial markets have raised their bets in recent weeks that interest rates could reach 6% this year and any dent to this view may hurt sterling. The latest lending data for April could show that mortgage approvals declined for the third consecutive month, suggesting the strain on the housing market is rising. We expect approvals to ease to 110,000 but mortgage lending should have remained robust. The manufacturing PMI, on Friday could show a modest drop, easing to 53.7, from 53.9 in April.
Data from the euro zone this week are likely to keep upward pressure on bond yields. Figures from Germany will take most attention, with financial markets looking for clues about what level interest rates will end the year, given a hike to 4% in June has already been signalled. The 'flash' estimate of EU-13 CPI may show inflation returned to 2% in May for the first time since August 2006.
Jeavon Lolay, Senior Economist
www.lloydstsbfinancialmarkets.com
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