Economics Weekly: Array of UK, US and Euro Zone Data; Bernanke Testifies

Key UK events this week include updates on consumer confidence, house prices, the second estimate of Q4 gdp and speeches by two BoE MPC members. Data including employment and retail sales have surprised to the upside over the last two weeks, forcing futures markets to make further revisions to their expectations of substantial rate cuts this year. However, dovish speeches by MPC hawks Besley and Sentance last week made clear the BoE is likely to cut rates below 5.25% if downside risks to the economy materialise.

In the US, Fed chairman Bernanke will testify on the economy on Wednesday. The Fed last week scaled back its 2008 estimate of gdp growth to 1.6% but revised up its inflation forecast to 2.1%. Bernanke may elaborate on how he Fed balances the diverging paths for these two principal drivers of monetary policy, and he is expected to reaffirm that the Fed is ready to take further action to prevent a worsening of the housing and economic downturn. Revised Q4 gdp data, house prices and new and existing home sales will be released during the course of the week.

The next ECB meeting is still two weeks away and this means that markets will concentrate on interim data, like leading activity indicators and inflation. The latest German IFO survey and the EC confidence indicators will give detail on how businesses and consumers are reacting to financial market events and rising commodity prices. There are very few signs that inflation will abate in the near term especially after the latest spike in oil and food prices. Euro zone inflation data for January is due on Friday.

Economic data from the UK last week reaffirmed the resilience of the economy and defied the more pessimistic forecasts based on the impact from the financial market turmoil and the higher cost of funding. Whether it is reflected in lower house prices or tighter access to credit, to date it has not caused a dramatic slowdown in consumer spending. Retail sales rose in January at the fastest rate in 11 months. Prospective weakness in household spending was cited last week by MPC members Besley and Sentance, two of the BoE's most prominent rate hawks, for expecting weaker UK economic growth. Overall, the comments signalled the level of alert on the MPC to a challenging backdrop for growth that could justify another cut in interest rates. With this in mind, markets will this week focus on updates by the CBI on retail turnover on Tuesday and on consumer confidence and mortgage activity on Friday. In between, the 2nd estimate of Q4 2007 gdp is forecast to be confirmed on Wednesday at 0.6% q/q, with slightly stronger household spending potentially mitigating a greater drag from net trade. The Nationwide will publish the results of its February house price survey. MPC members Lomax and Gieve may add to the dovish BoE chorus during their respective speeches on the economy on Tuesday ad Wednesday.

A busy week of US data releases will be dominated by Fed chairman Bernanke's testimony to Congress on Wednesday (repeated on Thursday). The Fed last week published its updated 2008 and 2009 staff estimates for growth and inflation and it is primarily in this context that markets will judge the likelihood of more US rate cuts as the central bank tries to stave off a more severe economic downturn at the expense of higher inflation. House prices are due on Tuesday, and existing and new housing inventories data on Monday and Tuesday may give some indication about future levels of residential construction. The second estimate of Q4 2007 gdp is due on Thursday and may show an upward revision from the advance 0.6% estimate due to a lower trade deficit in December. Personal income and spending data for January complete the data releases on Friday.

A stronger than forecast rebound in the euro zone services PMI last Friday cemented the outlook of no change in ECB interest rates in March. With the revised ECB estimates of 2008 growth and inflation looming in two weeks time, markets will judge this week's German IFO survey, the EC confidence surveys and euro zone inflation data in the light of a possible shift towards an easing bias.

Chart 1: Even after the latest spike, inflation adjusted prices of gold and oil are some way off their all-time highs

Chart 2: UK mortgage activity data is due this week and may offer some indication of future house prices

Wage inflation is the key to further UK rate cuts

Can wage inflation stay low if price inflation accelerates?

UK price inflation is heading back up again, yet the central bank has cut interest rates twice in three months. How can it justify this when its inflation target is 2% and the actual rate of inflation is above this level and likely to rise even further in the months ahead? The answer, of course, is that the central bank is looking for economic growth to slow such that inflation falls in the medium term.

The Monetary Policy Committee (MPC) noted in the minutes of the February meeting that 'the central projection suggested that there was most likely to be some spare capacity in the economy, even if interest rates followed the path implied by market yields. That would therefore help to ensure that inflation returned to the 2% target in the medium term'. This is illustrated in chart a, which assumed Bank rate would be cut to 4.5% in 2008 and stay there and that UK economic growth falls to well below 2% by the middle of 2008 before recovering back to trend in 2009. But the MPC was still very worried about inflation and also said in the February minutes: 'the Committee expected that higher energy and food prices would raise inflation, possibly quite sharply, in the coming months. Producer input and output prices were already rising rapidly and the decline in the sterling ERI would boost import costs further.'

Chart a: MPC expects below trend gdp growth to add spare capacity and keep inflation low...

Further, the MPC went on to say that: 'measures of inflation expectations had not fallen in line with actual CPI inflation following its peak during 2007. There was a risk that above-target CPI inflation in the near term would affect inflation expectations, and hence have some tendency to persist in the medium term.' The MPC is clearly worried therefore that the rise in price inflation will feed through into wage inflation and so into widespread inflation pressure in the economy as a whole, which would be very costly to reverse.

Latest data show that price inflation is accelerating...

So what does the actual recent evidence show? Is inflation accelerating and is the economy slowing? Chart b shows that producer output price inflation is at its highest since 1992 (producer input price inflation is at an 18 year high) and consumer and retail price inflation is accelerating. Worryingly for the MPC, survey data also show that household inflation expectations are at their highest since they began to be recorded in 1995 and have not fallen back in line with the fall in CPI in the second half of 2007.

Chart b: ...but UK price inflation is accelerating again after falling in late 2007

This would seem to suggest that the MPC is right to be concerned about inflation pressures. And the key question is, can wage inflation stay low if consumer price inflation rises even further above the 2% target in 2008, as the MPC and most other forecasters suggest? Chart d shows that there is a close link between price and wage inflation and that wage inflation is remarkably low at the moment relative to price pressure. Our forecast for CPI inflation suggests that it will rise well above target this year, probably prompting a second open letter from the Governor of the BoE to the Chancellor in just over a year.

Chart d: Will wage inflation stay low if retail price inflation does not quickly fall?

However, the UK labour market remains benign, see chart c, with annual earnings growth of 3.8% in the year to December including bonuses, and 3.7% if bonuses are excluded. Moreover, the claimant count unemployment rate stayed at 2.5% and so there was a continuation of the low wage inflation, low unemployment rate of the last 15 years, where reduced volatility (in price inflation and economic growth) has resulted in a much better wage and unemployment mix than at any time since the 1960s. We therefore have two implied criteria from the February MPC meeting minutes that would neeed to be met before interest rates are cut any further in the months ahead. The first is that the economy must slow; the second is that wage inflation must remain low.

Chart c: Can the benign mix of low unemployment and weak earnings growth continue?

Data show UK economic growth remaining more robust than expected...

UK employment grew by 175,000 in the three months to December, and the UK's employment rate rose to 74.7%, the highest since records began in 1971. Can wage inflation stay low in this environment? Moreover, if growth in the economy remains strong - it rose 0.6% in the quarter to December - and does not slow as is suggested in chart a, can the MPC cut rates any further? Certainly, economic data in 2008 so far do not suggest that the economy is slowing as sharply as is implied in the MPC's gdp fan chart. Retail sales rose 0.8% in January, and were up by 5.6% in the year. BRC and CBI retail surveys showed a better outcome than had been expected. The housing market data seem to have stabilised, albeit at lower levels, and both the services and the manufacturing PMIs are still well in positive territory. Finally, broad M4 money supply rose by 1.4% in January, contrary to many expectations of a fall, and the annual rate accelerated to 12.9%, the fastest rate since before the credit crisis broke in August 2007. As chart f shows, economic growth and wage inflation are linked: faster growth, higher wage inflation; weaker growth, lower inflation. If the economy does not slow quite soon, then wage inflation could accelerate, removing one of the main reasons why some members on the MPC agree that there is scope to cut base rate even as consumer price inflation rises further above its 2% target.

Chart e: Will rising CPI inflation put earnings growth under upward pressure?

Chart f: Will economic growth slow before wage inflation accelerates?

...raising the risk that the MPC may not be able to cut rates, particularly if pay inflation also accelerates

As the MPC noted in the minutes of its February meeting at which Bank rate was cut 0.25% to 5.25%: 'The Committee needed to balance the risk that a sharp slowing in activity would pull inflation below the target in the medium term against the risk that elevated inflation expectations would keep inflation above target.' This is indeed a delicate task but in some ways would be easier than if the economy does not slow and inflation accelerates, then the MPC may have another problem - will it have to raise interest rates even with a credit market crisis still unfolding in global markets that could affect UK companies?

Full report here

Lloyds TSB Bank

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