Bank of England Interest Rate Decision Dominates U.K. Economic Events Week Commencing 3 March

Markedly faltering UK growth and the very real risk of a sharp economic downturn mean that further interest rate cuts are clearly on the Bank of England's agenda. Nevertheless, next week's meeting of the Monetary Policy Committee is highly likely to prove too soon to yield the next 25-basis-point interest rate cut to 5.00% given current elevated inflationary pressures. 

All nine MPC members voted for February's 25-basis-point interest rate cut from 5.50% to 5.25%, with arch-dove David Blanchflower wanting an even larger reduction of 50 basis points to 5.00%. Nevertheless, while the minutes of the meeting indicated that further interest rate cuts are likely to be needed, it appeared that the majority of the MPC remain reluctant for now, at least to cut interest rates aggressively, as they try to carry out the very difficult balancing act of containing inflation over the medium term while trying to support growth. This reinforces the impression from the February Quarterly Inflation Report.

Indeed, the Quarterly Inflation Report indicated that only limited further reductions in interest rates are likely. Significantly, the central forecast in the Inflation Report shows that consumer price inflation is still modestly above its 2.0% target level in two year's time based on market expectations which imply that interest rates fall to 4.5% by the end of 2008 and then essentially stabilize at this level through 2009. However, inflation is modestly below the 2.0% target level in two years time if interest rates stay at the current level of 5.25%.

The Bank of England remains particularly concerned that a near-term sharp spike up in inflation resulting from higher energy, food, and import prices will lift inflation expectations and thereby affect the medium-term behavior of price and wage setters. While the latest Citigroup/Yougov survey shows that expected inflation over the next 12 months eased back to 3.1% in February from 3.3% in January, it should be borne in mind that January's level of 3.3% was the highest since the series started in 2005. Although February's easing back to 3.1% was a step in the right direction, it was still up markedly from 2.7% in December and substantially above the Bank of England's target inflation rate of 2.0%. Should inflation expectations moderate over the coming months, it would significantly enhance the Bank of England's scope to cut interest rates more aggressively to try to contain the downside risks to growth.  However, if inflation expectations prove sticky, then the Bank of England is likely to remain cautious in its cutting of interest rates. 

The Bank of England's concern over inflationary risks will also have been stoked by latest survey evidence indicating that retailers, service companies, and manufacturers are all still looking to raise prices in order to pass on their elevated input costs resulting from high energy, food, and raw material prices. Indeed, the CBI's quarterly distributive trades survey showed that a balance of +50% of retailers reported that selling prices were up year-on-year in February, which was the highest balance since August 1996. Furthermore, a balance of +48% of retailers expect prices to rise, which is the highest level since November 1996.

Further evidence of major inflationary pressures building up through the supply chain was provided by headline annual producer output inflation surging to 5.7% in January, its highest level since mid-1991. While producer output prices were substantially pushed up by higher petroleum and food prices, this was by no means the whole story as the core rate spiked up to 3.2% from 2.7% in December and 2.4% in November. In addition, producer input prices jumped 2.6% month-on-month and 18.9% year-on-year in January, as the weaker pound added to the upward pressures coming from high oil prices and a surge in wheat prices. This jump in input prices maintains pressure on manufacturers to try to raise their prices. Worryingly, the output prices index contained in the manufacturing purchasing managers' survey surged to a record high in January, as manufacturers looked to pass on sharply rising input costs.  Meanwhile, the prices charged sub-index in the service sector's purchasing managers' survey climbed to a 10-month high in January, while the input prices sub-index remained very close to the series high.

At least though, there is currently little evidence that pay is rising. Latest hard data show that annual earnings growth remained muted in December, while Industrial Relations Services (IRS) reported that median pay settlements stood at 3.5% in the three months to January. This was unchanged from the reading for the three months to December, which was revised down from a previously reported 3.7%. Consequently, pay settlements in January remained in the 3.0-3.5% range that held through 2007. Furthermore, IRS reported that median pay settlements in January alone were limited to 3.25%, while the editor of the report also indicated that data collected since the survey were "on the low side" and there was "a good chance that pay settlements could nudge down in the coming months."

Meanwhile, the Bank of England expects growth to slow markedly this year in the face of tighter credit conditions and significant downward pressures on consumer spending. Furthermore, the MPC regards the growth risks to be to the downside.

Latest data and survey evidence generally reinforce concern about the economic outlook. While GDP growth in the fourth quarter of 2007 was confirmed to have slowed only modestly to 0.6% quarter-on-quarter and 2.9% year-on-year, the breakdown of the data was worrying and did not bode well for future growth. Consumer spending growth slowed sharply, business investment contracted, and exports also fell. Growth would therefore have been significantly softer in the fourth quarter, but for a sharp rise in inventories and also an increased contribution from government spending.

Furthermore, latest survey and data indicate that the consumer is increasingly struggling under mounting burdens. Consumer confidence sank to a 13-year low in February, while the CBI distributive trade survey showed that the balance of retailers reporting that sales were up year-on-year retreated markedly to a 15-month low of -3% in February. This was substantially below the long-term average of +18%. Meanwhile, the housing market continues to falter markedly, with Nationwide reporting that prices fell by a further 0.5% month-on-month in February, following declined in each of the previous three months. Consequently, annual house price inflation moderated to 2.7% in February. This was the lowest level since November 2005, and was down from 4.2% in January and a peak of 11.1% in June 2007.

We expect the Bank of England to trim interest rates by a further 25 basis points to 5.00% in May, but it could move in April if the economy appears to be slowing more sharply, wage growth remains contained, and inflation expectations appear to be at least stabilizing. Further out, we still expect interest rates to be down to 4.50% by the end of the year and believe that they will fall to 4.00% in the first half of 2009, despite the Bank of England's February Quarterly Inflation Report indicating that further monetary policy easing is likely to be limited. We are more pessimistic than the Bank of England on growth prospects, and believe that interest rates will accordingly fall further as extended below-trend growth dilutes underlying inflationary pressures.

Key Economic Data Releases

Next week is fairly light in terms of the number of economic data releases, but significant attention will be focused on the purchasing managers' surveys for the manufacturing (out Monday) and services sector (out Wednesday). These are closely watched by the Bank of England and will give important early information on how the economy performed in February ahead of the Monetary Policy Committee's interest rate decision on Thursday. However, given the MPC's concern about current elevated inflation risks, it would likely take evidence of extremely weak output, orders and confidence in the surveys to prompt a further 25-basis-point interest rate cut to 5.00% as soon as next Thursday. 

Both surveys are expected to be pretty soft, without being weak enough to lead the Bank of England to enact a back-to-back interest rate cut on Thursday. Latest hard data and survey evidence indicate overall that—while it is not collapsing—the manufacturing sector is being significantly pressurized by a toxic mix of slowing domestic demand, tighter credit conditions, elevated oil prices, and faltering demand in key export markets. The recent marked overall retreat in the pound offers some relief to manufacturers, but it is unlikely to fully offset these serious dampening factors. Consequently, we forecast the manufacturing purchasing managers' index to have eased back to 50.3 in February, from 50.6 in January, and a peak of 56.1 in August 2007. This would be the weakest level since August 2005, but still marginally above the 50.0 level that indicates unchanged activity.

Meanwhile, the Bank of England will focus on the survey's output prices charged sub-index. This surged to a record high of 57.9 in January as manufacturers looked to pass on sharply rising input costs. Furthermore, latest data show that annual producer output price inflation jumped to 5.7% in January, which was its highest level since mid-1991. The Bank of England will be hoping that the prices charged index moved lower in February, thereby indicating that generally softer manufacturing activity is diluting companies' pricing power. This needs to increasingly happen for the Bank of England to enact significant further interest rate cuts over the coming months.

The dominant sector has shown clear signs of losing significant momentum recently after extended buoyancy. Indeed, the business activity indexof the purchasing managers' service sector survey retreated to a 55-month low of 51.9 in November, and was not far above that level at 52.5 in January. This was also not that far above the 50.0 level that indicates unchanged activity and was well below a peak of 60.6 in December 2006. Furthermore, the January survey pointed to further softness ahead as incoming new business remained close to November's four-and-a-half year low, while backlogs of work contracted at the fastest rate since April 2003 and business expectations sank to a six-year low. We expect the business activity index to have edged back down to 52.3 in February.

While the Bank of England will pay significant attention to the activity and orders indices of the purchasing managers' survey, it will also be very interested in the prices indices. The prices charged sub-index climbed to a 10-month high in January, while the input prices sub-index remained very close to a series high, thereby maintaining pressure on services companies to raise their prices. Any further rise in the price indices in February would limit scope for the Bank of England to cut interest rates significantly further in the near term at least.

Meanwhile, the construction purchasing managers index (out on Tuesday) is forecast to retreat to 52.8 in February, after falling to 53.9 in January, from 56.0 in December and  a peak of 64.8 in August 2007. January's weakness reflected weaker expansion in commercial construction and civil engineering activity. Furthermore, the housing activity index indicated contraction in the sector for a second successive month in January. This indicates that housebuilders are very wary about the outlook for the housing market, as evidence consistently points to it slowing markedly in the face of increased affordability pressures and tightening lending practices. With the commercial property market in dire straits, the housing market cooling markedly and weakened public finances likely to increasingly limit scope for infrastructure investment, there is a growing risk that the construction sector could be in for an extended hard time.

Muted housing demand, tighter lending practices and stretched affordability is expected to continue to feed through to contain house prices over the coming months. We expect the Halifax lender to report during the week that house prices fell 0.2% month-on-month in February, having been flat in January. Consequently, annual house price inflation is seen retreating to 4.2% in the three months to February, from 4.5% in the three months to January and a peak of 11.4% in the three months to August 2007.

 By Howard Archer

3 Mar - Manufacturing Purchasing Managers Index, February: 50.3