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Economics Weekly

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Will the BoE Governor have to write an open letter?

Fri, Jun 20 2008, 10:01 GMT
by Trevor Williams

Lloyds TSB Financial Markets

One of the key questions this week is whether the Governor of the Bank of England will have to write an open letter to the Chancellor explaining why inflation is more than 1% above the 2% target and what he is doing about it. Our forecast shows consumer price inflation hitting 3.3% in May, the highest rate since the measure became the target in 2003 and the highest since July 1992. Other UK data will suggest that the economy, though slowing, has not ground to a halt, with retail sales up 4% in the year to May – based on a fall of 0.2% in the month. Monetary policy meeting minutes, due Wednesday, will suggest whether official interest rates are on prolonged hold, as we suspect, rather than rising, as markets expect. In the US, after some poor inflation data, attention switches to the housing market, producer prices and production. A modest US growth outcome looks likely in Q2. For the Euro area, the data releases this week will focus on consumer prices, with a record high expected. High commodity prices have contributed to a sharp rise in inflation expectations everywhere, see chart a.

• In the US, focus is on the housing market and the data for producer prices and industry. Producer prices are expected to rise sharply following the strong import price data last week. Industrial production is expected to show a modest rise, as the weaker currency does seem to be boosting exports and this is reflected in a narrower current account deficit, data due on Tuesday. Weakness in the housing market will persist for some time yet, as the excesses of the last decade will take time to work off. This week, housing starts and permits in May are likely to show further falls. Will the Fed raise rates in this situation? We think that this is unlikely until it is clear that the credit crisis is over and robust growth resumes.

• For the UK, the focus is on whether annual consumer price inflation rises above 3% in May. The signs are that it will, especially after the very strong core producer price data for May released last week, see chart b below. With inflation expectations climbing as a result of higher commodity prices and consumer price inflation, will the Bank of England raise rates? We think not, the credit crisis is still hitting the economy, a rate rise now will not help prevent the rise in consumer price inflation to above 4% in the months ahead and the slowdown underway will itself help to reduce inflation pressures in 2009. Our view is that it is best for the Bank to wait until 2009 to see where the economy and inflation is then, after all monetary policy in the UK is not loose. Minutes of the June MPC meeting released on Wednesday will give us some insight into the official thinking on this issue. Retail sales growth is easing but only slowly, as consumers show more resilience than many supposed. Money supply growth remains firm with a 0.7% rise expected, but is also slowing in annual terms. Companies are still borrowing, up 14% in the year to April, and though business confidence in the CBI survey may remain negative, it is nowhere near recession levels. However, the main focus will be on the inflation trend within the survey. Meantime, the public finances are expected to continue to worsen as the economic slowdown deepens.

• In the euro area, the focus will be on inflation, as well. Expectations amongst households about inflation are at a very high level, which has prompted the ECB to talk of raising rates in July. Data on Monday may confirm that they will, if inflation is at or around 3.6%. But recent data for PMIs in services and manufacturing suggest that the pace of growth is easing. This will limit any interest rate increases in the months ahead.

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Published on  Fri, Jun 20 2008, 10:06 GMT