PRESSURE MOUNTS ON THE BANK OF ENGLAND TO CUT INTEREST RATES AGAIN, BUT MAY LIKELY PROVE TOO EARLY FOR MOST MPC MEMBERS

SUMMARY

Next Thursday's interest rate decision from the Bank of England is becoming a closer call by the day. Recent weak data and survey evidence relating to consumer confidence, retail sales, the housing market, and manufacturing activity heightens concern that the U.K. economic downturn is deepening and adds to the pressure on the Bank of England to quickly cut interest rates again despite current elevated inflation levels and risks. We still modestly lean towards the view that the next cut in interest rates, from 5.00% to 4.75%, will come in June. Nevertheless, further very weak data and surveys over the next few days could yet trigger an interest rate cut on Thursday (the April purchasing managers survey for the services sector could be particularly influential). Further out, we anticipate that interest rates will fall to 3.75% by early 2009 as extended below-trend growth increasingly undermines companies' pricing power and limits wage growth. We see U.K. GDP growth being limited to 1.6% in 2008 and 1.4% in 2009.

With signs growing that the U.K. economy is slowing markedly in the face of major headwinds and credit conditions remaining very tight, the Bank of England is under serious pressure to cut interest rates for a second successive month at the conclusion of its May policy meeting on Thursday. At the same time though, inflation pressures remain elevated and are currently showing few signs of easing, thereby continuing to severely limiting the Bank of England's room for maneuver.

The difficult situation currently facing the Monetary Policy Committee (MPC) as it tries to juggle slowing U.K. growth and serious downside risks to the outlook with current elevated and still-rising inflation was reflected in the three-way split in the MPC's voting in April. Timothy Besley and Andrew Sentance reinforced their hawkish reputations by voting for interest rates to remain unchanged at 5.25%, while arch-dove David Blanchflower was in favor of a larger interest rate cut from 5.25% to 4.75%. The other six MPC members judged that a weakening growth outlook meant that the downside risks to inflation over the medium term had increased relative to the upside risks, thereby warranting the 25-basis-points interest rate cut to 5.00% that was duly enacted   

The minutes of the April meeting also highlighted the MPC's ongoing very difficult position as it faces serious downside risks to the growth outlook, but also current elevated inflation pressures. The committee is currently particularly concerned that current elevated inflation levels—primarily resulting from higher utility and food prices, as well as a markedly weaker pound—could lift inflation expectations and, thereby, have significant second-round effects through affecting the behavior of price and wage setters.

Latest comments by MPC members suggest that splits persist on the appropriate course for monetary policy. David Blanchflower has made it clear that he believes the Bank of England needs to step up its cutting of interest rates as he fears that the United Kingdom is in serious danger of suffering recession and a housing market crash. However, Bank of England Governor Mervyn King's recent testimony to parliament's Treasury Committee suggested to us that he did not consider the U.K. economic slowdown to be marked enough, at this stage at least, to step up the pace of monetary policy easing given current elevated inflationary pressures. In addition, a recent speech by Andrew Sentance strongly suggested that he was against another interest rate cut as soon as May given inflation risks. 

Survey evidence and data released since the April MPC meeting will have done little overall to alleviate the MPC's concerns on inflation. Indeed, the April Citigroup/YouGov inflation expectations survey showed that inflation is expected to reach 3.8% over the next 12 months. This is the highest level since the series started in 2005, and up from the 3.6% expected in March and the 3.1% in February. It is also substantially above the Bank of England's target inflation rate of 2.0%. Furthermore, latest surveys show that companies are currently still trying hard to lift their prices charged in order to pass on their elevated input cost and protect their margins. For example, the April CBI industrial trends survey revealed that the balance of manufacturers expecting to raise their prices over the next three months only stabilized +25 in April, which is one of the strongest levels on record. Furthermore, the balance of manufacturers raising their domestic prices over the past three months spiked up to +21% in April from +13 in January, taking it to its highest level in 13 years. Similarly, the April managers' purchasing managers' report showed the output prices index climbing to its highest level since the survey began in 1999

There is some recent good news on the inflation front. Wage growth remains muted and there is currently little evidence that it is picking up. Furthermore, the retail price deflator fell at an increased rate of 1.2% year-on-year in March. This indicates that retailers believe that there is a growing need to offer incentives to get increasingly pressurized consumers to shop. Meanwhile, consumer price inflation was stable at 2.5% in March, thereby defying expectations of an increase, as the core inflation rate remained down at 1.2%. Nevertheless, consumer price inflation is clearly above the Bank of England's 2.0% target rate and still seems likely to reach 3.0% at least this summer, as higher energy and food prices impact along with the weaker pound.   

At the same time though, the MPC sees serious downside risks to the growth outlook, particularly resulting from tighter credit conditions, as well as weaker prospects for global growth. Latest data show that GDP growth slowed for a third successive quarter in the first quarter of 2008, and at an increased rate. Indeed, quarter-on-quarter growth of 0.4% was the weakest performance since the first quarter of 2005, clearly below trend and only half the 0.8% growth rate achieved in the second quarter of 2007. The annual growth rate slowed to 2.5% in the first quarter of 2008 from a peak of 3.2% in the second quarter of 2007.

Furthermore, latest data and survey evidence suggests that the U.K. economic slowdown is deepening further. While retail sales were surprisingly resilient overall during the first quarter of 2008, fears that the consumer could be about to retrench substantially have been raised by a markedly weaker CBI distributive trades survey for April and news that consumer confidence has deteriorated to its lowest level since late-1992. In addition, latest mortgage and house price data and survey evidence have heightened concerns that the housing market could suffer an extended, sharp correction. Meanwhile, latest survey evidence from the CBI and the purchasing managers point to the manufacturing sector recently losing significant momentum, while the service sector is also clearly faltering.

Adding to concerns over the economic outlook, credit conditions currently remain tight, despite the recent introduction of the Bank of England's generally well-received Special Liquidity Scheme. For example, three-month LIBOR rates are currently still up around 5.82%, compared to the Bank Rate of 5.00%.    

Signs that the U.K. economic downturn is deepening and ongoing tight credit conditions heap pressure on the Bank of England to cut interest rates again sooner rather than later. Consequently, an interest rate cut from 5.00% to 4.75% is very possible on Thursday, although we suspect that most MPC members would currently prefer to delay acting until June, given elevated inflation risks. Further markedly weaker economic data and surveys over the next few days could very well trigger an interest rate cut on Thursday.

Further out, we anticipate that interest rates will fall to 4.00% by the end of 2008 and to 3.75% in the first quarter of 2009, as extended below-trend growth increasingly undermines companies' pricing power and limits wage growth. Specifically, we forecast U.K. GDP growth to slow sharply from 3.0% in 2007 to 1.6% in 2008, and then moderate further to 1.4% in 2009. This is substantially less than the Chancellor's growth forecasts of 1.75-2.25% in 2008 and 2.25-2.75% contained in March's budget and, therefore, has very worrying, negative implications for the public finances. 

MAIN UK ECONOMIC INDICATORS TO BE RELEASED

The coming week is fairly light for U.K. data releases, but those that are out could yet play a key role in determining whether or not the Bank of England cuts interest rates again as soon as Thursday. We suspect that most Bank of England's Monetary Policy Committee members would prefer to wait until June before relaxing monetary policy further given current elevated inflation levels and risks. Nevertheless, if next week's data are markedly weaker it would raise concern that the U.K. economic downturn is deepening and thereby significantly intensify pressure on the Bank of England to take further action to support growth. 

Particularly influential will be the purchasing managers' service sector survey for April (out on Tuesday). The dominant services sector has lost significant momentum in recent months after extended buoyancy. We expect the business activity index to have retreated to a five-year low of 51.7 in April from 52.1 in March and 57.6 in August 2007, as it continued to be significantly hit by the credit crunch and financial market volatility, and also by markedly weakening housing market activity. Slowing consumer spending is also likely to hurt service sector activity.

While the Bank of England will pay significant attention to the activity and orders indices of the purchasing managers' survey, it will be just as interested in the prices indices. The prices charged index eased back modestly in March from February's record high, thereby suggesting that softening activity could be starting to dilute service companies' pricing power. Nevertheless, the prices charged index was still uncomfortably high, while the input prices index was at a record high, thereby maintaining pressure on service companies to try to raise their charges.

The Nationwide lender is likely to report on Wednesday that consumer confidence weakened further in April after dropping to its lowest level in March 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 April since November 1992, with the sub-index measuring consumers' perception of whether or not it is a good time to buy at its lowest level since November 1990.

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, which makes for depressing headlines. Consequently, the Bank of England's cumulative cutting of interest rates by 75 basis points between December and April has done little to raise spirits, particularly as much of the impact has been countered anyway by the credit crunch and elevated money market interest rates.

Manufacturing output (out Wednesday) is forecast to have edged up just 0.1% month-on-month in March, causing year-on-year growth to moderate to 1.3% from 1.9% in February. Industrial production is also seen rising 0.1% month-on-month in March, with year-on-year growth slowing to 0.9% from 1.3%.

Latest survey evidence from both the Confederation of British Industry (CBI) and the purchasing managers indicate that the previously resilient manufacturing sector is now being increasingly hit by slowing domestic demand, weaker demand in key export markets, elevated energy and commodity prices, and tighter credit conditions. While the weaker pound is providing a very welcome boost to U.K. manufacturers, this is being increasingly countered by slowing growth in the Eurozone and a stagnant U.S. economy. 

By Howard Archer 

6 May - Service Sector Purchasing Managers Index, April: 51.7

7 May - Nationwide Consumer Confidence Index, April: 74
7 May - Industrial Production, March (Month-on-Month): +0.1%
7 May - Industrial Production, March (Year-on-Year): +0.9%
7 May - Manufacturing Output, March (Month-on-Month): +0.1%
7 May - Manufacturing Output, March (Year-on-Year): +1.3%