Economics Weekly
Policy Decision Getting Tougher for MPC
MPC unsure about what to do...
What is the MPC to make of what is going on? It has seen a widening of interbank interest rate spreads in the last month, increased volatility in equity and foreign exchange rate markets and rising oil and commodity prices that are boosting inflation pressure. It is no wonder that at the March interest rate meeting there was a split, with 7 voting to leave rates at 5.25% and 2 voting for an immediate cut of ¼%. Moreover, the actual minutes from that meeting highlight the dilemma now facing the MPC. On the one hand, a further tightening of credit conditions could result in growth slowing more sharply than expected in the central projection – this would reduce medium-term inflation risks and so argues for lower rates. On the other hand, further rises in commodity prices, compounded by the weaker pound, coupled with elevated inflation expectations mean that there are upside risks to inflation in the medium term, despite slowing economic activity, implying that rates should remain on hold at best. The charts in this publication, from a to e, give the source and sense of this better than expected economic performance, the rise in price inflation pressure and the threat from higher inflation expectations.
So what is the MPC to do? The answer, in our opinion, for the next meeting in April is nothing. Our monthly monetary policy checklist actually suggests a very contrarian view: that based on the data available since the last MPC meeting there is a slight bias to raise rates. Now, this is not going to happen, but it does show that unless a lot of the downside risks that many are expecting do not start to appear soon, the next move in interest rates may not be downward but sideways for many months and then up when the credit crisis eases.
...so left interest rates at 5.25% in March...
The minutes of the March meeting said that the majority on the MPC think that: 'Both the manufacturing and services CIPS/NTC activity measures picked up in February, and, together with January's data, suggested that output growth in the first quarter might be a little above the level expected at the time of the February Inflation Report.' The committee went on to add that, 'There was little evidence that the downside risks to inflation from a sharper-thanexpected slowdown in activity, flagged as a risk in the February Inflation Report, had begun to crystallise.' However it did note that: '... the impact of the deterioration of credit conditions remained very uncertain'. Overall, however, these quotes do not suggest a committee that is about to cut interest rates, though the minutes did say that: '...the central view was predicated on the assumption of some further modest easing of Bank Rate...' With this in mind what have the data since the last MPC meeting showed about the economy, especially as the minutes said that not enough had changed in March to justify a rate cut and that the committee would focus on reviewing new economic information each month for the implications for the inflation target in the medium term?
...as some figures suggest that monetary policy should be tightened...
We have put together a monetary policy scorecard, see table 1, and awarded marks of -1 for those that have eased since the last MPC meeting, +1 for that have risen and 0 for those that were relatively unchanged. Rather surprisingly, a summary of this list of 19 variables shows a small bias towards raising rates. The main reasons are that activity is holding up remarkably well and that inflation pressure appears to have increased since the March MPC meeting. To cite some of these variables: retail sales volumes jumped 1% in February and the January figure was revised up to over 1%. Manufacturing output rose in February by 0.4% and the monthly NIESR gdp figure increased from 0.4% in January to 0.5%. Admittedly, the rate at which unemployment is falling was only 2,800 in February, down from 9,100 in January, suggesting a slower pace of economic expansion. But the wider ILO survey measure showed that the rate of unemployment fell to 5.2% from 5.3% in the three months to January, as employment rose strongly. Moreover, the CBI survey showed a rise to +7 from +3 in firms' output expectations in January, a huge surprise to some, given the unfolding tightening of credit conditions, uncertainty in financial markets and worries about economic growth in the US and Europe.
Table 1: UK Monetary Policy scorecard
...with inflation even more of a threat
But it was the price inflation data that were unequivocally bad, pointing to greater price pressures. Consumer price inflation hit a 9 month high of 2.5%, with core inflation up 0.3% in February. Import price inflation rose, as the currency fell further and producer input and output prices stayed high. Household's annual inflation expectations in the Bank of England's own NOP survey hit a record peak of 3.3% in February and the pound fell to its lowest level since 2003, falling 13% on a trade weighted basis since its 2007 peak. Nonetheless, wage inflation was fairly flat, with a modest fall in actual earnings and a no change in the rate that excludes bonuses. But just reciting these figures does not give a feel for the relative importance of each, and it is still likely to be the case that uncertainty about the eventual impact of the credit crisis, the economic slowdown in the US and the fact that the UK labour market is still not seeing a passthrough from price inflation to wage inflation, will prompt a further modest cut in rates.
However, financial market uncertainties suggest rates will still be cut slightly
May looks the most likely month for a rate cut from the MPC. After that, it becomes more difficult to see reductions as annual consumer price inflation rises towards 3%, and possibly further above, which would prompt an open letter to the Chancellor from the Governor of the Bank of England, only the second in 2 years. However, the high level of uncertainty at present is generating a wide range of possible outcomes, with some looking for Bank rate to fall to 4% by the end of the year and some, including us, to just 5%.
Chart a: Economic growth just below average...
Chart b: ...as Q1 economic activity remains resilient
Chart c: Sharp fall in exchange rate underway...
Chart d: ...putting pressure on price inflation...
Chart e: ...as inflation expectations rise ominously
Quiet week for UK economic data; busy US and Euro zone calendar
UK economic data this week will be limited to the CBI distributive trades survey for March and the final figures for Q4 2007 gdp. Current account figures for Q4 are also due and are likely to underline the economic imbalances due to deteriorating deficits on the balance of trade and investment income. The US calendar features a number of speeches by Fed officials and updates on consumer confidence, home sales, durable goods orders and personal spending. The indicators may provide some indication on the rate of the economic slowdown in Q1. Indicators of business confidence are due in the euro zone, including the German IFO. ECB president Trichet will testify to the EU Parliament.
A quiet week for UK economic data lies ahead but this is unlikely to cool the intense debate over the timing of the next reduction in base rates. The recurring rise in UK Libor rates beyond what the Bank of England may have projected in the February Inflation Report has increased some unease and led two members of the MPC to vote for lower rates in March. Even though fundamentally, strong economic data like CPI and retail sales may not have changed the Bank's short term outlook for growth and inflation, the comments in the MPC minutes last week on the money markets, the US economy, and a more downbeat regional Bank agents' survey, infer a greater degree of uncertainty about the risks to growth and inflation. The fact that the Bank was forced to intervene at two occasions last week and provide emergency funds will do nothing to allay concerns about a general tightening in lending standards. Three-month Libor rose to 5.99% on Friday, pushing the spread over base rate to nearly 75bp, the widest since 18 December 2007. The CBI distributive trades survey and Q4 current account data will attract most attention in the week ahead, giving clues about the outlook for household spending and the growing imbalances from global trade and investment flows. Much stronger than forecast retail sales figures for February were released last week and challenged the more negative assessments that the economy is rapidly losing momentum. But we expect the CBI distributive trades survey on Thursday to report a slight decline in reported retail turnover in March, with the index forecast to drop to -5 from -3 in February. On Friday, we expect Q4 2007 gdp growth to be confirmed at 0.6% q/q, but a history of backward revisions means that the y/y growth rate of 2.9% could be adjusted.
A raft of economic data, the provision of liquidity by the Fed, and the interpretation by FOMC members of recent data and credit market trends will be in focus in the US. The tendency of economic data to surprise to the downside has not diminished and this has given way to fears that output growth and the labour market slowed considerably in the present quarter. House prices, job security and personal income growth are pivotal in how consumers rate their own circumstances and this may impact trends in home sales and residential construction. House prices and consumer confidence are due on Tuesday, personal income and spending data are due on Friday. Durable goods orders are a proxy of business investment and to what extent this is supporting Q1 gdp growth should emerge on Wednesday when February figures are released. Thursday's weekly claims data will shape expectations about the total level of employment in March. The ominous rise in claims last week to 378,000 suggests more jobs were probably lost at the end of Q1. Final Q4 2007 gdp data is forecast to be confirmed at 0.6% annualised. Core inflation data for February will be released with the personal income and spending data on Friday and is forecast to show no change from January at 2.2%. This may give the Fed some reassurance that despite the sharp cut in interest rates, core inflation is not accelerating.
French and German business confidence data and the testimony of ECB president Trichet head up the euro zone calendar. A higher than expected outcome for the German March manufacturing PMI last week suggests that the any decline in the IFO on Wednesday should be limited, as companies continue to enjoy solid overseas demand. ECB president Trichet is likely to reiterate the bank's uncompromising position on interest rates on Wednesday due to above target inflation of 3.3%
Chart 1: Relentless rise in 3-mth Libor over Base rate may force the BoE to provide more emergency funding
Chart 2: The rising level of delinquencies could result in a more prolonged downtrend for US house prices
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