We expect the second release of GDP in the fourth quarter of 2010 (out Friday) to show that GDP contracted modestly less than the 0.5% quarter-on-quarter (q/q) rate estimated in the preliminary release. While GDP in that quarter was hit substantially by December's severe weather, the Office for National Statistics (ONS) surprisingly indicated that underlying output was essentially only flat during the quarter.

Specifically, we are looking for the rate of contraction to be revised to 0.4% q/q. This revision would result in year-on-year (y/y) growth in the fourth quarter being raised to 1.8%, from the currently reported rate of 1.7%. The preliminary estimate of GDP in the fourth quarter of 2010 was based solely on the output side of the economy, and the fact that the economy contracted was a real surprise, let alone that it declined 0.5% q/q.

Latest data on the output side of the economy does not point to any significant upward revision to the fourth-quarter 2010 performance. On the positive side, ONS data now show that construction output fell 2.5% q/q in the fourth quarter of 2010, which was less than the 3.3% q/q drop reported in the preliminary national accounts. Nevertheless, the impact will be only marginal, given that construction output only accounts for 6.3% of GDP and the revision was not massive. Also, the upward revision in construction output has been countered by the ONS revealing that industrial production actually grew 0.7% q/q in the fourth quarter of 2010 rather than by 0.9% as estimated in the preliminary national accounts data (industrial production accounts for 17.2% of GDP). The implication is therefore that any marked upward revision to GDP in the fourth quarter of 2010 would require an upward revision to activity in the dominant services sector, which is currently reported to have contracted 0.5% q/q.

Details of GDP on the expenditure side of the economy will be released for the first time.It seems likely that consumer spending could have contracted modestly, given that retail sales volumes fell 0.1% q/q in the fourth quarter and spending on services appears to have declined. Investment may have suffered a modest correction after spiking 3.4% q/q in the third quarter. It is also likely that stocks rebuilding made a reduced contribution to GDP growth in the fourth quarter or could even have been negative after adding 0.3 percentage point to third-quarter growth. Meanwhile, evidence suggests that net trade was essentially flat in the fourth quarter as increasing imports countered improved exports.

We expect GDP to rebound 0.8% q/q in the first quarter of 2011 as some of the activity lost to December's severe weather is made up. Just as the fourth-quarter 2010 contraction overstated the economy's weakness, so is the first quarter of 2011 likely to overstate its strength.

In fact, we expect growth to moderate appreciably after the likely first-quarter rebound,as the fiscal squeeze increasingly kicks in, some temporary growth drivers wane (notably restocking) and consumers limit their spending in the face of serious headwinds (notably including squeezed purchasing power due to high inflation and muted wage growth, high unemployment, the increasing fiscal squeeze, elevated debt levels, tight credit conditions, and a weak housing market). Specifically, we project GDP growth to moderate to 0.3% q/q in both the second and third quarters before edging up to 0.4% q/q in the fourth quarter. This would result in overall GDP growth of 1.6% in 2011.

Minutes of February Bank of England MPC Meeting

Given the major uncertainty over when exactly the Bank of England is likely to start raising interest rates (and how quickly interest rates are likely to increase) much attention will be focused on Wednesday's release of the minutes of the February meeting of the Bank of England's Monetary Policy Committee (MPC). At its February meeting, the MPC kept interest rates at 0.50% and left the stock of quantitative easing unchanged at GBP200 billion.

The Bank of England's Quarterly Inflation Report for February suggested that interest rates might have to rise two or three times in 2011—with a first move by midyear—if consumer price inflation is to be brought down to 2.0% on the two-year policy horizon. Nevertheless, comments by Bank of England Governor Mervyn King at the press conference accompanying the release of the report suggested that it was far from certain that interest rates would rise as soon as the second quarter, or as quickly over the year. Pointedly, King stated, "some people are running ahead of themselves and saying that we are pre-announcing or laying the ground for a rate rise. That decision has not been taken and won't be taken until we get to the next meeting or the following meeting, or it may be many quarters."

It appears that there is a growing split among the nine MPC members over what should happen with interest rates. Of key interest in the minutes of the February MPC meeting therefore will be whether any more MPC members joined Andrew Sentance and Martin Weale in voting for higher interest rates. There are rumors that at least one other MPC member did so, and this would increase the likelihood of the Bank of England raising interest rates in the near term.

It will also be important if the minutes indicate that any other MPC members were very close to voting for an interest-rate hike in February. Of course, it should be noted that in January, one MPC member, Adam Posen, was still in favor of looser monetary policy through increasing the stock of quantitative easing by GBP50 billion to GBP250 billion. It will also be interesting to see if Posen retained this view in February.

The outlook for interest rates faces massive uncertainty, both in the immediate future and over the longer term. The one certainty is that interest rates will rise, be it sooner or later. Whether the Bank of England acts by May is likely to depend critically on how well the economy performs over the coming weeks as the fiscal tightening really kicks in. Wage growth developments will also be key.

We fully acknowledge that an interest-rate hike from 0.50% to 0.75% is highly possible by May, but for the time being we are sticking with the view that the Bank of England will hold fire until the latter months of the year. This reflects our belief that growth will slow appreciably over the next few months and that a soft labor market will prevent higher inflation expectations feeding through to lift wage growth significantly. The Bank of England is very aware that tighter fiscal policy is going to really kick in over the coming months and will weigh down on growth. Despite the rebound in retail sales in January, there are serious concerns over the outlook for consumer spending, which we believe warrants caution on hiking interest rates now. Even a small hike in interest rates risks hitting consumers' psychology hard at a time when confidence is low and falling.

Furthermore, we maintain the view that even if interest rates do rise sooner, the probability remains that they will move up relatively gradually and stay very low compared with past norms, as monetary policy will need to stay loose for an extended period to offset the impact of the major, sustained fiscal squeeze. Consequently, we retain the view that interest rates will only rise to 2.00% by end-2012.

Public Finances in January

The public finances data for January (Tuesday) are expected to show a modest surplus compared with a small shortfall in January 2010. January is always a favorable month for the public finances, as it is a key month for tax receipts. The economy's markedly improved economic performance should have significantly lifted tax receipts. The higher value-added tax rate (it was lifted in both January 2010 and 2011) will also lift tax receipts. Meanwhile, unemployment benefit claims have fallen 168,100 overall from the October 2009 12-year high of 1.6278 million, thereby helping to limit the rise in public expenditure. Specifically, we expect the Public Sector Net Borrowing Requirement (PSNBR), excluding financial interventions, to have been in surplus by GBP1.5 billion in January (i.e., a net repayment) compared with a small deficit of GBP977 million in January 2010.

A serious problem for the government, though, is that interest payments are increasing appreciably. The government is highlighting this as a key reason why there should be no scaling back or delaying of the measures to improve the public finances.

The public finances show modest overall improvement so far during fiscal year 2010/11 and the government is currently on course to meet its public finance targets for the year, although much will clearly depend on how well growth bounces back in the first quarter of 2011, after the shock GDP contraction in the fourth quarter of 2010. Specifically, the PSNBR, excluding financial interventions, fell to GBP118.4 billion during April–December 2009 from GBP126.8 billion a year earlier.

If current trends are replicated over the whole fiscal year, the PSNBR would come in around GBP146 billion, meaning that Chancellor George Osborne would modestly undershoot his target PSNBR of GBP149 billion in 2010/11. In November, the Office for Budget Responsibility trimmed the forecast SNOB in 2010/11 from GBP149 billion to GBP148.5 billion.

House Prices in February and Mortgage Approvals in January

The British Bankers Association is expected to report on Wednesday that mortgage approvals for house purchases were limited to 29,500 in January, after slumping to a 23-month low of 28,726 in December. This was down from 29,696 in November and the last peak of 46,168 in December 2009. It was also less than half the average monthly level of 58,329 seen since 1997. January's modest improvement is expected to primarily reflect the fact that mortgage approvals were hit to a limited extent in December by the severe weather during the month. The underlying trend in mortgage activity is likely to have remained very soft in January.

Meanwhile, the Nationwide lender is expected to report during the week that house pricesfell 0.2% month-on-month (m/m) in February, after edging down 0.1% m/m in January. With the exception of December, when prices rose 0.4%, house prices have been falling or flat every month since May 2010 on the Nationwide measure. Nevertheless, the y/y drop in house prices is expected to narrow to 0.2% in February from 1.1% in January (which was the first annual drop since August 2009). This reflects the fact that house prices fell sharply in February 2010.

We expect house prices to trend down gradually in 2011, after losing ground overall in the latter months of 2010. Specifically, we suspect that house prices will fall around 5% in 2011 and end up losing around 10% from the peak levels seen in the first half of 2010. We believe that the fundamentals remain largely unfavorable for the housing market, even though recent signs that fewer houses are now coming onto the market could provide significant support for house prices if sustained. Even if fewer houses do come onto the market over the coming months, their effect is likely to be countered by ongoing low housing market activity reflecting the pressure on buyers.

The housing market is likely to be pressurized over the coming months by high and likely-to-rise unemployment, negative real income growth, the increasing fiscal squeeze, very low consumer confidence, and ongoing difficulties in getting a mortgage (particularly for first-time buyers).

Further bad news for the housing market is the now very real possibility that the Bank of England will start to raise interest rates within the next few months to counter above-target and rising inflation. Any early interest-rate hike would be bad news for the housing market and likely to weigh on prices—not just the rate rise itself but also the impact on potential house buyers' psychology resulting from the fact that they would be facing rising interest rates with the prospect of more to come.

Meanwhile, affordability measures are mixed. On the favorable side, mortgage payments as a percentage of disposable income are currently very low compared with past norms (but some mortgage interest rates have already risen). However, the house price/earnings ratio is above its long-term average. Specifically, Halifax data show that the ratio of house prices to earnings was 4.49% in January. While this was down from the last peak of 4.70% in April 2010, it is above the 1983–2010 average of 4.03%.

CBI Distributive Trades Survey for February

The Confederation of British Industry (CBI) distributive trades' survey for February (Thursday) is expected to be softer because of consumers reining in their spending in the face of serious headwinds, most notably including the increasing squeeze in their purchasing power coming from higher inflation and muted wage growth. The signs are that retail sales have moderated after being lifted appreciably in the early part of January by consumers eager to take advantage of the best of the bargains in the post-Christmas clearance sales and to beat the VAT hike from 17.5% to 20.0%. In addition, there was likely a temporary boost to sales in January from consumers looking to make purchases that they could not in December due to the bad weather.

Specifically, we forecast the survey to show that the balance of retailers reporting that sales were up y/y declined markedly to an eight-month low of +20% in February from +37% in January and +56% in December.

The likelihood is that consumer spending will be muted in 2011 in the face of serious headwinds and will significantly hold back GDP growth. Higher inflation (fueled by January's VAT hike) and muted earnings growth are increasingly squeezing purchasing power. Meanwhile, unemployment is high and likely to rise, other elements of the fiscal squeeze will increasingly bite as the year progresses (for example, employers' national insurance contributions will rise in April), and debt levels are elevated. On top of this, the weakness of the housing market is not good news for consumer spending.

Furthermore, the very real likelihood that the Bank of England will raise interest rates sooner rather than later is not good news for consumer spending prospects. Even if the Bank of England only edges interest rates up, it will affect consumer psychology as people are bound to see the move as the first in a series of hikes.

Consumer Confidence in February

The GfK/NOP consumer confidence index (overnight Thursday/Friday) is forecast to have weakened appreciably further in February to a two-year low. Specifically, we expect the index to have fallen to -32 in February after plunging to -29 in January from -21 in December. This would take the index markedly further below its long-term average of -8. The index stood at -14 in February 2010.

We expect consumer confidence to have been pressurized by higher inflation, increased expectations of rising interest rates, and deeper pessimism over the economic outlook following the shock news that GDP contracted 0.5% q/q in the fourth quarter of 2010. The substantial deterioration in confidence in January reflected markedly deepening consumer concerns over the economy's performance over the past 12 months and, especially, the outlook for the next 12 months. Furthermore, consumers were significantly more pessimistic over their past and future personal finances. Meanwhile, the "good time to make major purchases" sub-index nosedived by 22 points to -29 from -7. This was undoubtedly influenced substantially by January's VAT hike from 17.5% to 20.0%, fueling already-rising consumer price inflation.