Bank of England Policy Meeting the Key U.K. Economic Event for the Week Beginning 6 July

While there seems absolutely no doubt that the Bank of England's Monetary Policy Committee (MPC) will keep interest rates unchanged at a record low of 0.50% at the conclusion of its 8–9 July meeting, we believe that there is a strong possibility that it will expand the bank's quantitative easing program by a further £25 billion, to £150 billion.

Despite recent significantly improved economic data and survey evidence that suggest that the economy could have stopped contracting in the second quarter and, possibly, even eked out marginal growth, there are clear indications that the Bank of England's MPC continues to have major concerns and uncertainties about the timing, strength, and sustainability of economic recovery. Furthermore, there are still serious worries about the lack of bank lending to businesses, in particular, and consumers.

This is evident in both the minutes of the June MPC meeting and in testimonies in late June by Bank of England Governor Mervyn King and other MPC members to parliament's Treasury Committee. Specifically, the minutes of the June MPC meeting concluded that while "the risk of a continued sharp contraction in the near term had receded somewhat [...] there was no reason to conclude that the medium-term outlook for the economy, and thus, inflation had changed materially since the (May) Inflation Report had been finalized." In the May Inflation Report, the Bank of England had expressed concern that economic activity could be hindered for some considerable time to come by the ongoing need for financial institutions, households, and companies to adjust their balance sheets. In addition, the minutes of the June MPC meeting noted that "the growth rate of households' and private non-financial companies' money balances remained subdued" although it noted other tentative signs that the asset-purchase program was having a beneficial impact and that markets were functioning better.

While economic data and survey releases since the June MPC meeting have largely continued the improving trend, King told the Treasury Committee in late June that he still did not believe that "the big picture" had changed since the May Quarterly Inflation report. This report forecasted that on the assumption interest rates remain at 0.50% over the next two years and quantitative easing amounted to £125 billion (as currently planned), consumer price inflation would be just below the Bank of England's 2.0% target level on a two-year horizon. King also noted that bank lending remains weak, with lending to businesses falling. Furthermore, he expressed doubts that lending would pick up significantly until banks' have improved their balance sheets. This is obviously a significant danger to medium-term recovery prospects. Subsequently, released Bank of England lending data showed that M4 money-supply growth and M4 lending were muted in May, even though the Bank of England started quantitative easing in March.

Meanwhile, recently revised GDP data show that the recession started earlier and has been deeper than previously reported. Specifically, the economy started to contract in the second quarter of 2008 rather than the third, while the fall in GDP in the first quarter of 2009 was revised substantially from 1.9% quarter-on-quarter (q/q) and 4.1% year-on-year (y/y) to 2.4% q/q and 4.9% y/y. While in many respects this is old news and matters have moved on appreciably, it nevertheless means that the negative output gap is bigger than previously thought, which will further reduce inflationary pressures. This is likely to reinforce the Bank of England's concerns that consumer price inflation could remain below its 2.0% target level on a two-year horizon. It also suggests that current improved activity is coming from an even rockier base.

Ultimately, we suspect that interest rates are set to stay at 0.50% deep into 2010, and we also anticipate that the quantitative easing program will be extended further. The Bank of England currently has permission from the chancellor to extend its program by a further £25 billion, to a total of £150 billion, and we believe that it may well announce that it is doing this on Thursday. Furthermore, we think the Bank of England is likely to ask the government for permission to increase the upper limit of £150 billion for the quantitative easing program.

Key Economic Indicators to Be Released

Latest survey evidence and hard data for the manufacturing sector have shown substantial improvement since the sector suffered output's collapsing in the latter months of 2008 and the start of this year. Indeed, manufacturing output edged up by 0.2% month-on-month (m/m) in both March and April. These were the first increases in output since March 2008, and we believe that another rise of 0.2% m/m is likely in May. Even so, this would leave manufacturing output down by 11.8% y/y in May. We also expect industrial production to have expanded by 0.2% m/m in May, following an increase of 0.3% m/m in April. This would cause industrial output to be down by 11.3% y/y.

The manufacturing sector is currently clearly being helped by the major destocking that has now occurred and, to a lesser extent, the boost to competitiveness stemming from sterling's substantial overall depreciation. Nevertheless, manufacturers still face major problems, including muted domestic demand, difficult conditions in overseas markets, and intensified competition. Furthermore, manufacturers will be hoping that sterling does not strengthen further after rising markedly from its lows seen around the turn of the year.

Producer price data for June (out Thursday) should provide further evidence of manufacturers' limited pricing power in the face of recent, extendedly sharply contracting activity and orders, and intensified competition. Specifically, we expect producer output prices to have risen by 0.2% m/m in June, thereby causing prices to have fallen by 0.8% y/y. This would compare with a y/y drop of 0.3% in May and a record rise of 10.0% in July 2008. Core output prices are also forecasted to have risen by 0.2% m/m in June. This would bring the y/y increase down to 1.1% in June, from 1.2% in May and a peak of 6.3% in July 2008. Meanwhile, the consensus is for producer input prices to have risen by 0.8% m/m in June as oil prices rose further from their lows earlier in the year. Nevertheless, producer input prices are seen falling 12.2% y/y in June, reflecting the fact that oil and commodity prices are substantially lower than the levels seen a year ago despite their recent rise.

The trade deficit (out Wednesday) is expected to have narrowed anew in May after widening in April. Specifically, we see the total trade deficit narrowing to £2.6 billion in May after spiking up to £3.0 billion in April, from £2.7 billion in March and £2.4 billion in February. There are some signs that the sharp overall depreciation of sterling is providing increased support to U.K. exporters, although the upside for exports continues to be limited by muted domestic demand in key foreign markets—notably, the Eurozone and the United States. Meanwhile, imports are being limited by muted U.K. domestic demand.

Meanwhile, the Halifax lender is forecasted to report during the week that house prices edged up by 0.3% m/m in June, after rising 2.6% m/m in May. This would cause the y/y fall in house prices to moderate to 14.4% in the three months to June, from 16.3% in the three months to May and 17.7% in the three months to April. The Nationwide lender has already reported that house prices rose by 0.9% m/m in June, which was the third increase in four months and followed a rise of 1.3% in May. Consequently, the y/y drop in house prices on the Nationwide measure moderated to an 11-month low of 9.3% in June, from 11.3% in May and a peak of 17.6% in February.

Although we suspect that the Halifax will report a rise in house prices in June, we are still far from convinced that house prices have bottomed out and we certainly do not think that we are at the start of a renewed sharp upward trend. Housing market activity is still very low by long-term norms and economic fundamentals are still far from favorable for the sector. Admittedly, support for the housing market is coming from sharply reduced mortgage interest rates and a substantial fall in house prices from their 2007 peak levels. Surveys are also consistently reporting that house prices are currently being supported by the lack of new properties coming on the market.

By Howard Archer