Tight Credit Conditions Likely to Prompt Interest Rate Cut Next Week, Despite Still-elevated Inflation Risks

Summary: Tighter credit conditions, elevated market interest rates, evidence of markedly slower activity in the dominant services sector in March, and the growing danger of a sharp housing market correction have significantly shortened the odds of the Bank of England trimming interest rates by 25 basis points on Thursday. While current elevated inflation pressures mean that the Bank of England has to tread very carefully, we believe that the Monetary Policy Committee will decide that increased downside risks to the growth outlook warrant further preventative action and will cut interest rates from 5.25% to 5.00%. Further ahead, we expect interest rates to fall to 4.25% by the end of 2008 (as opposed to the 4.50% level that we had previously forecast) and to 4.00% in the first half of 2009, as extended, significantly below-trend growth dilutes underlying inflationary pressures and limits wage growth.

We believe that the heightened downside risks to the growth outlook stemming from markedly tighter credit conditions and high market interest rates has swung the odds significantly in favor of the Monetary Policy Committee into cutting interest rates from 5.25% to 5.00%, despite current elevated inflation risks. However, these inflation risks mean that it is not a stone dead certainty that the MPC will act on Thursday and the vote could well be close. Inflation risks also mean that if the MPC do act, the interest rate cut will be no more than 25 basis points from 5.25% to 5.00%, in contrast to the aggressive cutting of interest rates that recently has been carried out by the Federal Reserve in the United States.

Two of the nine MPC members (David Blanchflower and Sir John Gieve) voted for interest rates to be cut from 5.25% to 5.00% at the March MPC meeting, and it seems a safe bet that they will repeat this vote on Thursday. A minimum of three of the other seven MPC members, therefore, need to switch from the "no change" camp to the "cut" camp if interest rates are to come down on Thursday. The minutes of the March meeting indicated that elevated inflation risks meant that it was too soon last month for the other seven MPC members to be comfortable about cutting interest rates again, despite concerns about the growth outlook. Furthermore, there was a view that a back-to-back interest rate cut in March could be seen as indicating that the MPC was more concerned with the downside risks to growth than with achieving the Bank of England's 2.0% inflation target over the medium term.

However, credit conditions have tightened significantly since the March MPC meeting and market interest rates have increased. Indeed, when testifying to Parliament's Treasury Select Committee in late March, Bank of England Governor Mervyn King indicated that the recent further tightening in credit conditions meant that it had moved into a new and difficult phase. This is significant, as MPC members have repeatedly highlighted that tight credit conditions pose a particularly serious downside risk to consumer spending, business investment, and the housing market over the coming months. Indeed, when asked, Mr. King told the Treasury Select Committee that current credit conditions mean that the MPC is more predisposed to a cut in interest rates.

Furthermore, latest data and survey evidence suggest that U.K. growth could be starting to falter more markedly. In particular, the influential purchasing managers' survey indicated that service sector activity was at its second-lowest level (after November 2007) since May 2003. Purchasing managers' surveys also indicated that construction sector activity contracted in March for the first time since November 2001, and that underlying manufacturing activity softened in March. Although the headline manufacturing index was stable, the sub-components showed that output growth slowed to a 15-month low in March, while new orders contracted for a third successive month, and backlogs of work contracted appreciably.

Admittedly, retail sales were robust in the first two months of 2008, but this seems highly unlikely to be sustained given the serious pressures facing the consumer, including muted disposable income growth, tighter lending conditions, a substantially softer housing market, lower equity prices, and increased debt levels. Household purchasing power is also being dented by higher utility bills and elevated food prices, while many homeowners have to re-fix their mortgages at significantly higher rates. Furthermore, elevated concerns about the economic outlook are likely to lead consumers to tighten their belts. Unsurprisingly, consumer confidence plunged to a 15-year low in March, when the sub-index measuring consumers' perception of whether or not it is a good time to buy was at its lowest level since April 1995.

However, inflation remains a serious problem for the Bank of England and continues to severely limit its scope to cut interest rates aggressively to counter the downside risks to growth. Consumer price inflation climbed to a nine-month high of 2.5% in February, taking it further above the 2.0% target level. Furthermore, consumer price inflation seems set to reach 3.0% during the summer, as it is pushed up by rising utility prices and elevated food prices. While core consumer price inflation currently remains muted (it was just 1.2% in February), latest survey evidence shows that companies are increasingly looking to pass on their elevated input costs in order to help their margins.  In addition, producer output prices were up 5.7% year-on-year in February, which was the highest level with January for sixteen-and-a-half years.

Particularly worrying for the Bank of England, inflation expectations are elevated and rising. The March Citigroup/Yougov survey shows that the public expect inflation to reach 3.6% over the next 12 months. This was the highest level since the series started in 2005, and up from the 3.1% expected in February. It is also substantially above the Bank of England's target inflation rate of 2.0%. The latest speech by Mr. King stressed the need to ensure that a near-term sharp spike up in inflation resulting from higher energy, commodity, food, and import prices does not feed through to have sustained, significant second-round effects by lifting inflation expectations for an extended period. This could then adversely influence the medium-term behavior of price and wage setters, and increase the risk of a very damaging price-wage spiral developing. King also observed that some slowdown in growth is needed to curb inflation and that the Bank of England cannot ignore the current pick up in inflation.  He also stressed that the Bank of England cannot allow the economy to slow too sharply. 

There is some good news on the inflation front for the Bank of England: wage growth remains muted and there is currently no evidence that it is picking up. Latest hard data show that headline annual average earnings growth averaged 3.7% in the three months to January. Furthermore, headline annual average earnings growth amounted to just 3.5% in January, itself. This was partly due to lower bonus payments, although underlying earnings growth was also muted at 3.6% in January. Consequently, annual underlying average growth was limited to 3.7% in the three months to January, thereby remaining in the 3.4-3.7% range that held through 2007. Both the headline and underlying average earnings growth rates are markedly below the 4.5% growth rate that the Bank of England considers consistent with the 2.0% inflation target. Furthermore, Industrial Relations Services (IRS) reported that median pay settlements stood at 3.5% in the three months to February. This was unchanged from the readings for both the three months to January and the three months to December 2007. Consequently, pay settlements in February remained in the 3.0-3.5% range that held through 2007.

We believe that the increased downside risks to growth stemming from tighter credit conditions, coupled with signs that the economic downturn could be deepening, will lead the MPC to cut interest rates from 5.25% to 5.00% on Thursday, despite the inflation pressures. Further out, we expect the Bank of England to continue to enact gradual, but steady interest rates cuts. Specifically, we now forecast interest rates to fall to 4.25% by the end of 2008 and to 4.00% in the first half of 2009, as extended below trend growth increasingly undermines companies' pricing power and limits wage growth, thereby diluting underlying inflation pressures.

Main U.K. Economic Indicators to be Released

Lower buyer interest, reduced mortgage availability and higher costs and rates, and stretched affordability are expected to continue to feed through to dampen house prices over the coming months. We expect the Halifax lender to report during the week that house prices fell 0.5% month-on-month in March, following a 0.3% drop in February. Consequently, annual house price inflation is seen retreating to 2.2% in the three months to March, from 4.2% in the three months to February, and a peak of 11.4% in the three months to August 2007.

The Nationwide lender is likely to report on Wednesday that consumer confidence weakened further in March after dropping to its lowest level in February 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 March since February 1993, with the sub-index measuring consumers' perception of whether or not it is a good time to buy was at its lowest level since April 1995.  Consumer sentiment has been buffeted by a series of factors since last August, including the Northern Rock crisis, tightening lending conditions, financial market volatility, rising petrol food and utility prices, and a number of misfortunes undermining confidence in the government. On top of this, the economy is now clearly faltering and the housing market is cooling markedly. Consequently, the Bank of England's trimming of interest rates in both December and February has done little to raise spirits.

Manufacturing output (out Wednesday) is forecast to have edged up by just 0.1% month-on-month in February, although base effects would inflate the year-on-year increase to 1.5% (manufacturing output fell sharply in February 2007).

Industrial production is seen rising by 0.2% month-on-month and 1.3% year-on-year in February, after it was dragged down in January by sharp falls in mining and quarrying activity and lower utilities output. Going forward, we expect manufacturing activity to be increasingly pressurized by the credit crunch, slowing domestic demand and elevated energy and commodity prices. Furthermore, we strongly suspect that markedly slowing growth in the Eurozone and recession in the United States will weigh down on exports, although manufacturers should gain some respite from the weaker pound.

The British Chambers of Commerce quarterly survey (out Thursday) is likely to indicate that manufacturing and service activity lost momentum in the first quarter of 2008, but it will be interesting to see just how much weaker expectations are for the second quarter, given tighter credit conditions and a more difficult economic backdrop. The Bank of England will be hoping that the prices indices in the survey show some signs that softening activity is starting to dilute companies' pricing power. However, elevated input prices will have maintained pressure on companies to lift their prices. The survey will also give some indication as to which companies' investment plans are being scaled back in the face of tighter credit conditions and a more uncertain outlook.

Finally, the trade deficit (out Thursday) is expected to have been essentially stable in February. While U.K. exporters should increasingly benefit from the recent marked overall decline in the pound, this may not be sufficient to offset weaker demand in foreign markets. At least though, net trade is likely to benefit from U.K. imports being limited by significantly softer domestic demand over the coming months. Meanwhile, the Bank of England will be particularly interested in seeing how much import prices were pushed up in February by elevated oil, commodity and food prices, as well as the weaker pound

 

During week - HBOS Halifax House Prices, March (Month-on-Month): -0.5%

During week - HBOS Halifax House Prices, March (3-Month/Year-on-Year): +2.2%

9 April - Nationwide Consumer Confidence, March: not forecast
9 April - Industrial Production, February (Month-on-Month): +0.2%
9 April - Industrial Production, February (Year-on-Year): +1.3%
9 April - Manufacturing Output, February (Month-on-Month): +0.1%
9 April - Manufacturing Output, February (Year-on-Year): +1.5%
10 April - British Chambers of Commerce, First Quarter 2008 Survey
10 April - Visible Trade Balance, February (GBP/Mn): -7.6
10 April - Non-EU Visible Trade Balance, February (GBP/Mn): -4.3
10 April - Total Trade Balance, February (GBP/Mn): -4.2