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Bank of England: One and done?

Mon, Apr 23 2007, 16:42 GMT
by KBC Market Research Desk

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• UK inflation rises to above 3% in March cementing market’s expectations for a May rate hike
• Overall outlook for inflation to fall quite sharply in second half of the year still intact
• Rebuilding of profit margins still largest inflation risk
• Pay growth to remain subdued, as labour market softens
• Lagged impact interest rate increases and rise in Sterling exchange rate to slow economy
• 5.50% may turn out to be the peak of the cycle

Last week’s upward surprise in the UK inflation data cemented market’s expectations for a May rate hike, but also heightened rate hike expectations further out. We however strongly doubt whether the Bank of England will raise rates further beyond the May rate hike and expect 5.50% to be the peak in UK rates.

UK inflation rises to above 3% in March

Last week’s inflation data surprised friend and foe with the headline inflation rate rising to above the 3% level in March for the first time since 1992. As the current inflation rate is more than 1% above the target of 2%, Bank of England Governor King was obliged to write an open letter to the Chancellor of the Exchequer Brown to explain why inflation has risen above target and what the Bank will do about it.

In his open letter, King attributed the strong increase in inflation over the past year mainly to three factors:

• An unexpected sharp increase in domestic energy prices during the second half of the year, more than offsetting a fall in petrol prices
• A rise in food prices caused by a weather-induced global reduction in supply
• The rebuilding of profit margins by companies, which had previously been squeezed by the doubling in oil prices.

In March, higher petrol and furniture prices and an unfavourable base effect related to milk prices pushed the inflation rate unexpectedly to above 3% from 2.8% in February.

Overall inflation outlook unchanged

While the rise to above 3% is of course threatening, King remained confident that the overall inflation outlook has not changed. As such, the Bank of England still expects inflation to fall back quite sharply in the coming months. In the coming months, the substantial increases in household gas and electricity prices that occurred a year ago will drop out of the annual comparison, while the significant falls in those prices, which have already been announced will take effect. In the February inflation report, the central outlook was for inflation to fall a little below target of 2% by the end of this year, before settling at around the target during the following year.

But upside risks are still there

Regarding this rather favourable medium term inflation outlook two main risks should however be identified. First, a continuation of the rebuilding of profit margins by companies and secondly a rise in earnings growth as employees seek a compensation for higher inflation.

Regarding the first, in recent months output prices and business surveys have indeed indicated some increased pricing power of companies. The main question whether this will continue will mainly depend on the economic outlook going forward. In this context, we expect that a slowdown in domestic consumer spending as well as tough international competition due to the rise in sterling will prevent companies from raising prices much further.

Regarding earnings growth, we don’t expect any significant acceleration. In recent months, there was some pick-up in total earnings growth including bonuses, but this could be mainly related to bonuses paid in the financial sector, while underlying earnings growth remains subdued. This is also unlikely to change in the coming months, as the labour market shows some signs of softness. Indeed, in the three months to February, employment even fell 47K, whereas it was still up 147K over the year. At the same time, the ILO unemployment rate has risen from a historical low at 4.7% in 2005 to 5.50% currently. Large net migration is still seen as one of the driving forces that keeps earnings growth rather subdued, despite strong eco growth.

Weaker employment growth and the lagged impact of rate increases are likely to restrain real income growth and to slow consumer spending and housing market activity. Another rate hike in May would bring the Bank Rate at 5.50%, which was the peak in the previous cycle and which would mean that in less than a year UK interest rates have risen by 100 basis points. At the same time, the trade weighted Sterling exchange rate has risen towards its highest levels of the past decade. This constitutes a significant tightening of monetary conditions in the UK, which will slowdown economic growth sufficiently to refrain the Bank of England from raising rates further beyond 5.50%.

A 3-way split within the MPC

In this context, it’s also worth noting that there is currently no strong drive within MPC to hike rates further. The latest Minutes of the April meeting showed that the MPC is currently split into three major groups.

The first group, consisting of Blanchflower and most probably Lomax, did no see a compelling case for a rate hike in April, as there were both upside and downside risks to inflation and the near-term prospect for inflation was a fall towards the target in the next few months.

The second group, consisting of governor King, Gieve, Bean, Barker and Tucker, concluded that no rate hike was warranted in April, even while the balance of risks to inflation remained on the upside in the medium term.

The third group, consisting of Besley and Sentance, also thought that the balance of risks was to the upside and agreed that these were sufficiently strong to warrant an immediate rise by 25 basis points.

Even while the second group will most likely join the third group at the May meeting in favour of higher rates, we don’t expect them to support much more rate hikes. Indeed, since the January meeting only two members have backed higher rates in February and April. At the March meeting when there was some financial turmoil on the equity markets, even those ‘hawks’ joined the majority to leave rates unchanged and Blanchflower even started pushing for a rate cut. And even since inflation peaked above the 3% level, King still sounded rather relaxed about the inflation outlook saying that ‘the overall inflation outlook has not changed’.

With the near-term prospects for inflation to fall, we expect the Bank of England to pursue a wait-and-see stance following the May rate hike. Tomorrow’s testimony of the MPC at the Treasury Committee will provide some further insight in current thinking of the MPC.

Markets still expect two more rate hikes

In contrast to our view, markets currently discount still one more rate hike beyond the widely expected rate hike in May. As such, we believe there is an opportunity on the Gilt market to go long at the very short end, which is also supported by the technical picture in 2-year yields, as 2-year yields failed to break above the February high at 5.55% despite the upward inflation surprise.

Conclusion

Following last week’s upward inflation surprise markets raised their interest rate hike expectations in the UK and currently expect one more rate hike beyond May. We however expect the Bank of England to take on a more waitand- see approach and should not be surprised if 5.50% would turn out to be the peak of the cycle.

• Downlad full BoE: One and done?

Published on  Mon, Apr 23 2007, 16:44 GMT

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KBC Bank | Havenlaan 12, 1080 Brussels
http://www.kbc.be/dealingroom | piet.lammens@kbc.be

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