Bank of England Policy Meeting Features in UK Economic Week Commencing 2 April

BANK OF ENGLAND TO REMAIN IN WAIT-AND-SEE MODE

SUMMARY

The outlook for monetary policy in April is crystal clear, with no change in interest rates or the amount of Quantitative Easing (QE). Thereafter, the outlook is murkier, with views split as to whether further QE will occur. There are no doubts that interest rates are going to stay at the current record low level of 0.50% for some considerable time to come.

No change in monetary policy is a stone dead certainty at the conclusion of the April meeting of the Bank of England’s Monetary Policy Committee on Thursday. The Bank of England is clearly very much in wait-and-see mode, and Sir Mervyn King has indicated that future monetary policy moves will be driven by how growth and inflation develop over the coming weeks and months. On both the growth and inflation fronts, there is considerable uncertainty.

It is very possible that unchanged monetary policy will be the name of the game for the rest of 2012 and some considerable time beyond. Interest rates are clearly going nowhere anytime soon, and it is very possible that the Bank of England could be done on QE.

We have a sneaking suspicion that the Bank of England is not quite done on the QE front. This reflects our belief that the economy is likely to stutter over the coming months, and a majority of MPC members may feel that a final small helping hand is in order.

Specifically, we lean towards the view that the Bank of England will enact a final, smaller dose of GBP25 billion, very possibly in May, although it could be delayed until the third quarter.

ANALYSIS

There is little, if any, doubt the MPC will sit tight at its April policy meeting while February’s GBP50-billion extension to QE continues to be enacted and the committee monitors whether the UK economy is sustaining a likely (but by no means certain) return to modest growth in the first quarter and judges how high oil prices are affecting the inflation and growth outlooks.

While Adam Posen and David Miles voted for GBP25 billion more QE at the March MPC meeting, the minutes overall suggested the MPC is in no hurry to do any more QE. At the very least, it seems that most MPC members are happy to remain in wait-and-see mode until at least May, when February’s GBP50-billion extension to QE is completed. Furthermore, recent comments by two other MPC members, Martin Weale and Spencer Dale, suggest they believe there will not be a need for further QE.

It is not that surprising that Posen and Miles favoured more QE in March, as they had both wanted a GBP75-billion dollop in February rather than the GBP50-billion portion that was ultimately favoured by the MPC

While the minutes of the March MPC meeting conclude that “overall the Committee judged that the recent data had evolved in line with its expectations and that there had been little change to the balance of risk to UK activity and inflation,” there was increased concern over recent oil price developments and the outlook for oil prices. Having said that, the MPC noted that high oil prices would not only put inflation up but dampen growth prospects, so much would depend on the balance of these effects.

There was also concern within the MPC that another round of higher energy prices could lead to upward pressure on wages, as labour market slack may not prove such a restraining influence as in the recent past.

Meanwhile, the MPC believed that it “appeared more certain that underlying growth in the United Kingdom was likely to pick up in the near term.” Nevertheless, the MPC noted there were still serious downside risks to the outlook, and Posen and Miles remained particularly concerned over the risk that “persistently weak growth would damage the future supply capacity of the economy.”

Overall, it is apparent there are increasing divergences of opinion within the MPC over the outlook for consumer price inflation and the balance of risks.

Latest data do little to clarify the situation. News that the economy contracted by a slightly larger than previously reported 0.3% quarter-on-quarter in the fourth quarter of 2011 does not fundamentally change the story of an economy that saw fitful and muted overall growth in 2011, with a relapse in activity at the end of the year. Furthermore, that is history, and the Bank of England is very focused on the current state of the economy and the outlook.

The latest economic data and surveys have been mixed. Overall, it seems to us that economic activity saw an appreciable bounce in January but has since lost some momentum, although it has likely continued to expand. In fact, the OECD has forecast that UK GDP contracted 0.1% quarter-on-quarter in the first quarter, although we suspect it grew around 0.2–0.3%.

Meanwhile, although consumer price inflation moderated further to a 15-month low of 3.4% in February from 3.6% in January and the peak of 5.2% in September 2011, there are serious concerns that it will be stickier than previously expected over the coming months due to higher oil prices.

We believe that limited additional QE is more likely than not. We anticipate that economic developments will warrant further stimulative action despite recent signs of improvement. While we expect the economy will return to growth in the first quarter and avoid recession, we suspect that activity will be erratic and muted overall through the first half of 2012 at least, and then only pick up gradually in the second half. Meanwhile, we think consumer price inflation will trend down appreciably further over the coming months, although inflation clearly may well prove stickier than hoped for due to the strength of oil prices. Even if this is the case, underlying inflationary pressures still seem likely to be limited by extended below-trend economic activity, significant excess capacity, and ongoing wage moderation resulting from high and, likely, rising unemployment.

We lean towards the view that the Bank of England will do a final GBP25-billion more QE, taking the total up to GBP350 billion. This could happen in May, although it could be delayed until the third quarter.

Meanwhile, we maintain the view that interest rates will not rise until at least late 2013 and could stay put at 0.50% until 2014. Interest rates are clearly not going to be raised for some considerable time to come given the fragility of the economy and the need to counter extended tight fiscal policy. At the same time, there is little interest within the Bank of England for taking interest rates lower than 0.50%. Indeed, it is significant that even at the height of the 2008/09 recession the Bank of England did not take interest rates below 0.50%, which reflected doubts within the MPC that lower interest rates would have a net beneficial impact.

MAIN ECONOMIC RELEASES

Manufacturing Purchasing Managers’ Survey for March and Industrial Production in February

The manufacturing purchasing managers' survey (PMI, out on Monday) is expected to show that overall activity in the sector expanded modestly in March. Specifically, we forecast the PMI to have edged down to 51.0 in March after slipping back to 51.2 in February from an eight-month high of 52.0 in January. This would keep the index modestly above the critical 50.0 level that indicates flat activity.

We expect manufacturing output (out on Thursday) to have risen 0.2% month-on-month and 0.2% year-on-year in February. Manufacturing output edged up 0.1% month-on-month in January after rebounding 1.1% in December, which was the first increase since mid-2011. Overall, industrial production is seen rising 0.4% month-on-month in February, although this would still leave it down 2.1% year-on-year. Industrial production fell 0.4% month-on-month in January, as the small rise in industrial production was outweighed by a sharp fall in both utilities output and oil and gas extraction. Utilities output is likely to have been lifted by colder weather early in February.

Overall, the manufacturing sector seems to have returned to growth in the first quarter of 2012 after contracting sharply in the fourth quarter of 2011. Nevertheless, the manufacturing sector still faces significant challenges that are limiting the upside. Domestic demand for manufactured goods remains handicapped by a still-appreciable squeeze on consumers’ purchasing power, as well as by tighter public spending. Meanwhile, muted economic activity in the Eurozone is limiting export orders, although this is being countered by recently improved demand from Asia and the United States. In addition, the current spike up in input costs centred on higher oil prices is bad news for manufacturers, as it is squeezing their margins and exerting pressure on them to raise prices at a time when demand is fragile.

Construction Purchasing Managers’ Survey for March

We forecast the construction purchasing managers’ index (PMI, out on Tuesday) to have eased back to 53.0 in March after improving to an 11-month high of 54.3 in February from 51.4 in January. This would give an average of 52.9 in the first quarter of 2012, which is clearly above the 50.0 level that indicates no change. It suggests that construction output was positive in the first quarter after contracting 0.2% quarter-on-quarter in the fourth quarter of 2011. However, it must be borne in mind that the survey evidence for the construction sector recently has been consistently stronger than the hard data reported by the Office for National Statistics.

The February purchasing managers’ survey encouragingly not only showed activity improving to an 11-month high, but the more forward-looking elements of the survey also bode well for activity in the near term at least. Most encouragingly, the new orders index spiked up to a 21-month high while business expectations were at a nine-month high. Also encouragingly, activity expanded in all sectors in February, with both house building and civil engineering expanding anew after modest contraction in January, and commercial activity rising to a 17-month high.

However, it is evident the construction sector faces a tough environment and a battle to achieve sustained, decent growth. In particular, the government’s spending cuts are limiting overall expenditure on public buildings, schools, and hospitals. On top of this, house-building activity is likely to be constrained by persistently weak housing market activity, soft prices, and a still-worrisome outlook despite some recent improvement. If the economy fails to see sustained improvement over the coming months, there is the danger that construction activity will be hit by projects being put on hold or cancelled altogether.

On a positive note, the construction sector stands to benefit from government measures to boost infrastructure that were outlined in last November’s Autumn Statement. It remains to be seen just how effective these measures really are and how soon they will kick in. In addition, the government is looking to boost house building through instructing government departments to release state-owned land to be built on under a “Build Now, Pay Later” scheme. The government has announced a GBP-400 million ”Get Britain Building” investment fund aimed at reviving stalled house-building projects.

Service Sector Purchasing Managers’ Survey for March

The performance of the dominant service sector is key to just how much the UK economy has grown in the first quarter of 2012—if at all. The overall signs are that the services sector has returned to modest growth in the first quarter after output in the sector edged down 0.1% quarter-on-quarter in the fourth quarter of 2011. Latest hard data from the Office for National Statistics show that services output expanded 0.2% month-on-month in January after an increase of 0.3% in December, while the purchasing managers’ survey pointed to clear overall expansion in the first two months of the year, particularly in January.

We forecast the business activity index of the service sector purchasing managers' survey (out Wednesday) to have eased back to 53.0 in March from 53.7 in February and a 10-month high of 56.0 in January. This would still be clearly above the 50.0 level that is meant to indicate flat activity. It would also mean that the index averaged 54.3 in the first quarter of 2012, which would be appreciably above the fourth-quarter 2011 average of 52.5.

While the service sector does appear to be growing modestly again after contracting marginally in the fourth quarter of 2011, it is still faced by difficult conditions in the private sector and cutbacks in government spending. The Bank of England’s regional agents reported in their March summary of business conditions that “the rate of growth in businesses services turnover growth remained sluggish, with considerable variation across sectors.” The agents reported that “a fall in work for the public sector was also being felt by some service providers.”

Meanwhile, many consumer-facing service companies continue to be handicapped by the squeeze on consumer’s purchasing power and their need/desire to limit their discretionary spending. Nevertheless, the Bank of England’s regional agents reported in their March survey that annual growth of spending on consumer services had “edged a little higher.”

House Prices in March

The Halifax lender is expected to report during the week that house prices fell 0.3% month-on-month in March, which would leave prices down 1.7% year-on-year in the three months to March. The Halifax previously reported that house prices fell 0.5% month-on-month in February. While this followed a rise of 0.6% month-on-month in January, it was the fifth fall in house prices in seven months reported by the Halifax. The Nationwide has already reported that house prices fell 1.0% month-on-month in March after a rise of 0.4% in February and drops of 0.3% month-on-month in both January and December. House prices were down 0.9% year-on-year in March on the Nationwide measure.

We believe that house prices will trend gradually downwards over the coming months in the face of soft economic fundamentals and low consumer confidence. Specifically, we expect house prices to fall around 3% by the end of 2012. The housing market remains low compared to long-term norms. Although the economy has likely returned to limited growth in the first quarter, economic fundamentals still look far from rosy for the housing market, with unemployment high and likely to rise further, earnings growth muted, debt levels high, and the outlook uncertain. In addition, credit conditions may well tighten, making it harder for many people to get a mortgage. Indeed, the Bank of England reported in its March Quarterly Credit Conditions Survey that “overall availability of secured credit was expected to fall slightly in 2012 Q2.” It went on to report that “Consistent with the reduction in credit availability, lenders expected credit scoring criteria for granting loan applications to be tightened further in Q2.” Furthermore, some mortgage rates have risen recently due to lenders’ higher borrowing costs in wholesale markets, which could weigh down housing market activity.

The squeeze on consumers’ purchasing power should ease in 2012 as inflation falls back further, which may help house prices stabilize in the latter months of the year along with ongoing very low interest rates and hopefully a sustainable pickup in economic activity. Nevertheless, unemployment is likely to rise further and wage growth looks set to remain muted, so the overall environment will still be very tough for households. Furthermore, there is the danger that high oil prices will limit the drop in inflation.

By Howard Archer

2 Apr - Manufacturing Purchasing Managers Index, March: 51.2
3 Apr - Construction Purchasing Managers Index, March: 53.5
4 Apr - Service Sector Purchasing Managers Index, March: 53.5
5 Apr - Industrial Production, February (Month-on-Month): +0.4%
5 Apr - Industrial Production, February (Year-on-Year): -2.1%
5 Apr - Manufacturing Output, February (Month-on-Month): +0.2%
5 Apr - Manufacturing Output, February (Year-on-Year): +0.2%
During Week - Halifax House Prices, March (Month-on-Month): -0.3%
During Week - Halifax House Prices, March (Year-on-Year): -1.7%