Weekly Economic Data Preview by Lloyds TSB

The Bank of England Monetary Policy Committee (MPC) arguably faces its toughest test this week, facing rising pressure to lower interest rates at a time when inflation, its official remit, is at decade highs and still to peak. We expect a close decision but for the MPC to ultimately decide to maintain Bank rate at 5% on Thursday (in truth it could go either way). The extreme strains in money markets need to be calmed by targeted liquidity measures and it is unlikely that lowering official interest rates will provide much relief, especially to the problems in term lending. In addition, although recent data, such as the September PMI surveys, suggest the UK economy may have contracted in Q3, the risk was highlighted in the August BoE Inflation Report and so should not change the MPC’s medium-term outlook for inflation.

Bank of England faces tough decision

 

The Bank of England Monetary Policy Committee (MPC) arguably faces its toughest test this week, facing rising pressure to lower interest rates at a time when inflation, its official remit, is at decade highs and still to peak. We expect a close decision but for the MPC to ultimately decide to maintain Bank rate at 5% on Thursday (in truth it could go either way). The extreme strains in money markets need to be calmed by targeted liquidity measures and it is unlikely that lowering official interest rates will provide much relief, especially to the problems in term lending. In addition, although recent data, such as the September PMI surveys, suggest the UK economy may have contracted in Q3, the risk was highlighted in the August BoE Inflation Report and so should not change the MPC’s medium-term outlook for inflation. Waiting for the Inflation Report in November would make sense. The amended TARP package was finally approved by the House of Representatives last Friday, providing relief to global financial markets. However, recent weak economic data have raised pressure on the Fed to also consider lowering interest rates. The minutes of the September FOMC meeting published on Tuesday will be interesting in this regard. It is a relatively quiet week for data in the euro zone and so developments in funding markets may dominate. We look for the RBA to cut interest rates by 0.5% to 6.5% on Tuesday, responding to signs of slowing economic growth.

• The focus in the UK this week will be on the Bank of England interest rate decision on Thursday. The decision is finely balanced, with strong arguments for both maintaining Bank rate at 5% and cutting, possibly by 0.5% in our view. The minutes of the September MPC meeting showed an 8-1 vote for no change, with Tim Besley no longer favouring a 0.25% hike and David Blanchflower looking for a larger 0.5%
reduction. For the majority of the MPC, maintaining Bank rate at 5% was appropriate to balance the upside and downside risks to inflation but the committee was keen to stress that it would continue to make its judgement each month on the basis of changing evidence. So what has changed since the last meeting? Developments in global banking markets have certainly added further uncertainty about UK economic prospects. Money market funding has seized up, with term lending affected most. Three-month sterling Libor was at 6.27% on Friday, over 0.5% above the rate at the last rate decision. The latest BoE Credit Conditions Survey showed UK financial institutions expected to further scale back credit to households and companies in Q4, after reducing its availability by more than anticipated in the third quarter. The news on economic activity has been mixed, with official retail sales proving surprisingly strong but survey data in general proving weaker. On balance, a modest contraction in economic activity in Q3, the first since Q2 1992, is now likely.

However, acting as a crucial counterweight to these developments was a further rise in CPI inflation to 4.7% in August, signs of rising consumer inflation expectations and surging import prices. The inflationary threat has not diminished. Therefore the dilemma facing the MPC is effectively the same as last month, as the medium term outlook for inflation remains very uncertain. The best course of action may be to wait for the detailed forecasts provided by the Inflation Report in November. At that meeting with inflation having peaked (in our opinion), the MPC could contemplate a larger cut of 1/2%. We look for no change on Thursday but will not be surprised if rates are cut.
• Recent data suggest US economic growth has slowed significantly, primarily reflecting weakening consumer spending. Data on Friday showed non-farm payrolls declined by 159,000 in September, the ninth consecutive monthly fall, while the unemployment rate stayed at 6.1%. However, the robust performance of external trade, which provided the biggest contribution to gdp in Q2 since 1980, has been the
key reason the economy has avoided outright contraction in 2008. We expect US trade data, on Friday, to show a sharp narrowing in the deficit in August after a surprise rise in July. Developments in funding and banking markets may continue to provide the main highlights.
• The ECB held interest rates at 4.25% last week, however comments at the press conference suggested the balance had shifted slightly towards a more balanced stance. Nevertheless, the onus remained on minimising second round inflation effects to ensure medium-term price stability, suggesting no imminent cut in interest rates. The final estimate of euro zone Q2 gdp, on Wednesday, should confirm the
economy contracted by 0.2%. Recent data have raised the possibility of a further fall in Q3, confirming a technical recession.

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Jeavon Lolay, Senior Economist