Bank of England Interest Rate Decision Key Event for the U.K. Economy Week Commencing 4 August

The three-way split in the MPC's voting in July encapsulates the predicament that the Bank of England is in over a deepening and widening economic slowdown, yet elevated and still rising inflation. Indeed, the minutes note that the interest rate decision for all MPC members was "a difficult one". It was no surprise at all that David Blanchflower voted once again for an interest rate cut in July given his deep concerns about the risk of extended recession in the United Kingdom, while the hawkish Timothy Besley was always one of the most likely MPC members to favour a rate hike.

The general view seemed to be that the July MPC minutes were on the hawkish side, and that if the Bank of England does move interest rates in the near term, it will be more likely to raise them rather than cut them. There certainly seemed to be more debate about the case for raising interest rates than for cutting them, with the minutes noting that a raise in interest rates would "send a strong signal that it (the MPC) was focused on inflation and remained determined to bring it back down to target in the medium term."  In particular, the MPC remained particularly concerned that with consumer price inflation set to rise above 4% over the coming months and inflation expectations elevated and rising, there is a very real danger that high energy and food prices could have significant second-round inflationary effects through pushing up the prices of other goods and leading to higher wage growth.

The minutes also suggested that by keeping interest rates at 5.00% when the economy was slowing was "sending a strong signal of the MPC's commitment to reducing inflation."  There was also an acknowledgement that there has been bad news on both the inflation and growth fronts in recent weeks. Consequently, the upside risks to inflation in the near term were perceived to have risen, but so had the downside risks to growth and, hence, inflation over medium term.

We suspect that most MPC members are still firmly in "wait and see" mode and in no hurry to move interest rates, given the current major uncertainties surrounding both the medium-term inflation and growth outlooks.

We believe that latest developments have, overall, diluted the case for a near-term interest rate hike. In particular, the Citigroup/YouGov survey showing that both one-year and 5-10-year inflation expectations eased in July, and there continues to be no evidence of a pick up in wage growth. Meanwhile, evidence is mounting that the consumer is increasingly retrenching and that the economic downturn is deepening and widening. Indeed, wherever you look at the economy at the moment, there seems to be increasing weakness—be it the consumer, the housing market, manufacturing, service sector activity, or construction. Furthermore, credit conditions remain very tight, which the Bank of England acknowledges heightens the downside risks to growth. Consequently, we believe that mild recession is now more likely than not.

At the same time though, it is hard to see the Bank of England cutting interest rates any time soon given that inflation seems set to near 5.0% in the autumn and is likely to still be above 4.0% at the end of 2008. Inflation expectations are still far too elevated for the Bank of England's liking, while surveys show that companies are still keenly looking to raise their prices in order to protect their margins in the face of sharply rising input costs.

Consequently, we anticipate that interest rates will stay at 5.00% until the end of 2008 (although we would not rule out a cut in November), before being cut steadily to 4.25% by mid-2009 and to 3.75% by the fourth quarter of next year. We expect that very weak economic activity to increasingly contain and then dilute underlying inflationary pressures. We expect wage growth to remain muted as companies are under enormous pressure to contain their soaring costs, particularly as they face slowing demand. Furthermore, the rise in unemployment is picking up and this is likely to increasingly undermine workers' bargaining power, particularly as companies may well threaten to offset higher wages by cutting their workforces. Meanwhile, we expect markedly slowing demand and intensifying completion to increasingly undermine companies' pricing power. Indeed, we now believe that the economy will contract modestly in the second half of 2008,and will then be only flat in the early months of 2009. Growth is expected to remain below trend until the second half of 2010. As a result, we are set to cut our GDP growth forecasts to 1.3% in 2008, and a mere 0.4% in 2009.

MAIN ECONOMIC RELEASES

The construction purchasing managers index (PMI—out on Monday) is forecast to retreat to to a record low of 37.5 in July from 38.8 in June, 56.0 at the end of 2007, and a peak of 64.8 in August 2007. This would be the lowest level since the series began in 1997 and would also represent a fifth successive month of contracting activity in the sector (indicated by a reading under 50.0). July is likely to see further very weak residential activity. Indeed, the housebuilding index indicated that activity in the sector contracted at a record rate in June, and for the seventh month running. Specifically, the index dropped to a record low of 25.6 in June, which was a massive 24.4 points below the critical 50.0 level. Housebuilders are being hit extremely hard as housing market activity and house prices crumble in the face of elevated affordability pressures and very tight lending conditions. The CIPS also reported that commercial property and civil engineering activity contracted markedly in June. The preliminary second quarter national accounts data showed that construction output contracted by 0.7% quarter-on-quarter.

The service sector purchasing managers' index (out Tuesday) is forecast to show that the dominant services sector is now struggling markedly, in contrast to the extended buoyancy of recent years. We expect the business activity index to have fallen to 46.7 in July from 47.1 in June, 49.8 in May, and from 50.5 in April and 57.6 in August 2007. June was the lowest level since October 2001, and indicated a second month of contracting activity (below 50.0). The service sector is being significantly hit by the credit crunch and financial market volatility, as well as by sharply weaker housing market activity. Slowing consumer spending is also hurting service sector activity.

The Bank of England will be particularly interested in the prices charged index. This picked up in June despite contracting business activity and new orders, as companies tried to pass on some of their record-high input costs. The Bank of England is looking to markedly weaker activity to increasingly dilute companies' pricing power and, thereby, contain potential second-round inflationary effects from elevated energy and food prices.

Manufacturing output (out Tuesday) is expected to have been only flat month-on-month in June, after plunging 0.5% in May. Consequently, output is projected to have fallen 0.7% year-on-year. Industrial production is seen rising by a modest 0.2% month-on-month in June, which would represent a very modest rebound after production sank 0.8% in May. This would lead to production being down 1.1% year-on-year in June.

Latest survey evidence from the CBI and the purchasing managers indicate that the manufacturing sector is increasingly struggling in the face of slowing domestic demand, weakening activity in key export markets, elevated energy and commodity prices, and tight credit conditions. While a significantly weaker pound is providing a much-needed boost to U.K. manufacturers, this is being countered by significantly slowing growth in the Eurozone and a stagnant U.S. economy 

The Nationwide lender's consumer confidence index for July (out Wednesday) is forecast to show that sentiment deteriorated markedly further in July after dropping in June to its lowest level since the survey was first published in May 2004. GfK/NOP have already reported that their consumer confidence index was at its lowest level in in its 34-year history in July, with the sub-index measuring consumers' perception of whether or not it is a good time to buy also at a record low. Specifically, we project the Nationwide consumer confidence index to retreat to 57 in July, from 61 in June and 96 in July 2007.

Consumer sentiment is being buffeted by a plethora of factors including the increasing squeeze on purchasing power coming from elevated utility, food and petrol prices, the marked economic downturn, sharply falling house prices, the credit crunch and financial market turbulence, and a general lack of confidence in the government. On top of this, unemployment is now rising at an increasing rate, while there are fears that the Bank of England could raise interest rates.

Finally, muted housing demand, very tight lending conditions, and stretched buyer affordability seems highly likely to have continued to feed through to dampen house prices. We expect the Halifax to report during the week that house prices fell 1.5% month-on-month in July, following a drop of 2.0% in June. As a result, the year-on-year decline in house prices is expected to widen to 8.8% in the three months to July from 6.1% in the three months to June. Global Insight forecasts house prices to fall by 15% in 2008 and 12% in 2009.

By Howard Archer

4 Aug. - Construction Purchasing Managers Index, July: 37.5

5 Aug. - Service Sector Purchasing Managers Index, July: 46.7

5 Aug. - Industrial Production, June (Month-on-Month): +0.2%
5 Aug. - Industrial Production, June(Year-on-Year): -1.1%
5 Aug. - Manufacturing Output, June (Month-on-Month): 0.0%
5 Aug. - Manufacturing Output, June (Year-on-Year): -0.7%

6 Aug - Nationwide Consumer Confidence, July: 57

During week - Halifax House Prices, July (Month-on-Month): -1.5%