Bank of England policy meeting, inflation, unemployment, and retail sales feature in UK economic week starting 13 June

Bank of England to keep interest rates at 0.50% at June MPC meeting; uncertainty about outlook at peak as EU membership referendum imminent

The Bank of England will undoubtedly sit tight and keep interest rates at 0.50% at its June Monetary Policy Committee (MPC) meeting on Thursday, with its future policy decisions in large part a hostage to the result of the referendum on UK membership in the European Union that takes place the following week (23 June).

Much attention will likely focus on what the Bank of England has to say on the outlook for the UK economy in the event of a UK vote to leave the European Union. However, Governor Mark Carney has indicated that the Bank of England has said all that it is going to on the subject and that there is unlikely to be anything significant in the minutes of the June MPC meeting. The side favouring to leave the European Union has heavily criticised the Bank of England for its warnings of the likely short- and medium-term hit to the UK economy that it believes would be the consequence of the heightened uncertainty affecting business and consumer behaviour, as well as market repercussions. However, Carney has vigorously defended the right and appropriateness of the Bank of England to highlight the risks to the UK economy over the forecast horizon that would come from a vote to leave the European Union. Carney has argued that the Bank of England would not be doing its job properly if it did not analyze what it regards as the major risk to UK financial stability and a major influence on the economic outlook over the forecast horizon.

Assuming that the Bank of England does not make any new significant observations about the EU membership referendum and continues to base its views on the status quo assumption that the United Kingdom will remain in the European Union, the main area of interest in the minutes of the June MPC meeting is the committee becoming more concerned that the UK economy has lost underlying momentum and is more downbeat about its ability to regain momentum in the second half of 2016. There certainly appeared to be increased concern within the MPC at its May meeting that growth may not bounce back that strongly – at least initially – if there is a vote to remain in the European Union. In particular, the MPC highlighted the risk that there could be a prolonged drag on business spending if delayed projects took time to start. However, the MPC could have gained some reassurance by recent UK data relating to industrial production, retail sales, and trade that suggest that GDP growth may be holding up better than had seemed likely in the second quarter.

On the assumption that the United Kingdom votes to stay in the European Union, we expect the Bank of England’s eventual next move will be to raise interest rates from 0.50% to 0.75%, but not until May 2017. We suspect that the UK economy will strengthen in the second half of 2016, helped by reduced uncertainty. Furthermore, we expect consumer price inflation will trend gradually higher during the second half of the year and that there will also be a gradual pick-up in earnings growth due to the tightness of the labour market and April’s introduction of the National Living Wage.

Further out, we see interest rates only edging up to 1.00% at the end of 2017 and to 2.00% at the end of 2018.

However, we believe there is a significant risk that the economy may not bounce back after a vote to stay in the European Union because there is the danger that caution among businesses and consumers could persist following a likely soft second quarter. If this is the case, some MPC members could become increasingly tempted to trim interest rates.

EU referendum – Bank of England views on a vote to leave the European Union

At its May meeting, the Bank of England portrayed a gloomy outlook for the economy in the aftermath of an EU exit vote. The bank warned that growth would likely slow materially and unemployment would rise along with a probable increase in inflation (as a consequence of a possible sharp further depreciation in sterling). Indeed, the implication was that a recession would be a very real risk.

A combination of lower growth, higher unemployment, and higher inflation would have conflicting implications for what monetary policy the Bank of England should follow – particularly as to whether interest rates would need to go up or down. As the summary of the May MPC meeting noted “in such circumstances, the MPC would face a trade-off between stabilising inflation on the one hand and output and employment on the other".

The Bank of England concluded that "the implications for the direction of monetary policy will depend on the relative magnitude of the demand, supply and exchange rate effects”. It stressed “whatever the outcome of the referendum and its consequences, the MPC will take whatever action is needed to ensure that inflation expectations remain anchored and inflation returns to the target over the appropriate horizon”.

Main economic releases

Consumer and producer price inflation in May

Data out on Tuesday are expected to show that UK consumer price inflation rose back to 0.4% in May after dipping to 0.3% in April from a 15-month high of 0.5% in March. Nevertheless, this would keep consumer price inflation substantially below the Bank of England’s target rate of 2.0%. Inflation had previously trended up to March’s high of 0.5% from 0.3% in both February and January 2016, 0.1% in November 2015, and marginal deflation of 0.1% in both October and September 2015

The jump up in inflation to 0.5% in March followed by a dip to 0.3% in April was primarily because of the earlier Easter in 2016 compared with 2015. In particular, this caused air fares to rise markedly in March in 2016 rather than in April, as had been the case in 2015. There was also a significant hit on inflation in April in the price of clothing (particularly women’s outerwear), which likely reflected increased discounting as a result of cold weather hitting sales of spring/summer fashions and items.

Inflation is expected to have risen modestly in May primarily because of higher petrol prices as a result of oil prices reaching 2016 highs during the month. However, the effect of this will be limited by the fact that oil prices also firmed in May 2015. Sterling’s overall weakening during the early months of 2016 may also have boosted prices in May.

Consumer price inflation should trend gradually upwards during the coming months (on the assumption that the United Kingdom ends up voting to stay in the European Union in the 23 June referendum). Rising inflation should result from the impact of past sharp drops in oil, commodity, and energy prices gradually diminishing, magnified by current firmer oil and commodity prices. Brent oil is currently trading around USD51.00/barrel (having hit an 8-month high of USD52.86/barrel earlier this week), compared with January’s nearly 12-year low of USD27.10/barrel. This should be reinforced by sterling’s overall appreciable retreat from late-2015 peak levels, an expected renewed pick-up in earnings growth, and eventual elimination of the limited remaining slack in the economy as growth ramps up anew in the second half of 2016.

Consumer price inflation is seen reaching 1.0% in the fourth quarter of 2016 and 2.0% in late 2017. IHS believes that Brent oil prices will likely hover in a USD45–55/barrel range for some time before firming towards USD60/barrel in late 2017. Additionally, commodity prices will probably firm gradually. Meanwhile, GDP growth is seen limited to 1.9% in 2016 before strengthening to 2.4% in 2017, which should result in only gently rising core inflation. Earnings growth will probably firm after its softness in late 2015 and early 2016 amid a tighter labour market and April’s introduction of the National Living Wage, but it may well remain limited by some employers using low inflation as a reason to cap pay awards. Furthermore, an expected renewed pick-up in productivity (which relapsed markedly in the fourth quarter after earlier improvement in 2015) should limit the inflationary impact of rising earnings. Meanwhile, retailers, manufacturers, and services companies will likely find their pricing power limited for some time to come, given that the past prolonged squeeze on households’ purchasing power has made consumers price conscious. Indeed, supermarkets currently remain heavily engaged in a food-price war. Additionally, UK trading partners have very weak inflationary pressures, which should restrain import prices.

Should the United Kingdom vote to leave the European Union in the 23 June referendum, a likely sharp weakening in sterling would appreciably boost consumer price inflation. However, this would be partly countered by expected weaker economic activity stemming from heightened uncertainty.

Unemployment and employment

Data out on Wednesday are expected to show the labour market is essentially treading water amid increased business caution and uncertainty ahead of the 23 June referendum on UK membership in the European Union. Also hampering the labour market is relatively muted UK economic activity so far in 2016 and the National Living Wage coming in April. Global economic uncertainties have reinforced business caution. It is notable that the May Markit/REC report on jobs revealed that permanent placements had slowed to an eight-month low. The report commented “employers are showing uncertainty about hiring in the run up to the EU referendum”.

Specifically, employment is expected to have risen by a modest 42,000 in the three months to April, although this would take it to a new record high of 31.580 million. This would be similar to the increase of 44,000 in the three months to March, but would be markedly down from increases of 116,000 the three months to January, 205,000 in the three months to December 2015, and 267,000 in the three months to November.

The number of unemployed on the Labour Force Survey/International Labour Organization measure is seen edging down by 6,000 in the three months to March to stand at 1.685 million. This would follow a drop of 2,000 in the three months to March. It had actually edged up by 21,000 in the three months to February, which had been the first increase since the three months to July 2015. This compares with declines of 28,000 in the three months to January, 60,000 in the three months to December 2015, and 99,000 in the three months to November. The unemployment rate is seen remaining at 5.1% in the three months to April, where it has been since the three months to November 2015. It previously came down to 5.1% in the three months to November from 5.2% in the three months to October, 5.3% in the three months to September, and 5.6% in the three months to June 2015.

Finally, we expect the number of claimant count jobless (including universal credit) to have edged down by 2,000 in May to 735,800. This would follow a drop of 2,400 in April and an increase of 14,700 in March. Consequently, claimant count unemployment would still be above the record low of 725,400 seen in February. The claimant count unemployment rate is expected to remain at 2.1% in May after edging down to this level in April after a spike to 2.2% in March from 2.1% in February and January.

Assuming the United Kingdom remains in the European Union, we expect reduced uncertainty to boost growth and business confidence, thereby supporting the labour market and allowing the unemployment rate to edge down to 5.0% by end-2016 and then drop to 4.7% by end-2017. Nevertheless, employment growth will likely be increasingly limited by improving labour productivity as many companies look to make greater use of the workers they already have. Admittedly, labour productivity has been very weak for a long time and relapsed markedly in the fourth quarter of 2015 after finally seeing significant improvement in the second and third quarters, but we believe it will improve as a tightening labour market and April’s introduction of the National Living Wage (set at GBP7.20 for workers older than 25) increase the incentive for companies to get more out of their workers and to also invest in plants and processes to save labour. Indeed, the Bank of England’s regional agents’ March 2016 survey of business conditions reported that “employment growth intentions had eased over the quarter, reflecting a continued focus on raising productivity, heightened uncertainty, and a softening of demand growth”.

Additionally, survey evidence suggests the National Living Wage is making some companies more cautious about employment. In some sectors, companies are finding it hard to get the skilled and experienced workers that they need. The May Bank of England’s agents’ survey reported recruitment difficulties “remained above normal”, although there has been some easing in the problem. Meanwhile, cuts to welfare benefits are putting increased pressure on people to work.

Earnings growth in April

Average weekly earnings (regular pay) growth is expected to have increased to 2.2% in April after relapsing to 1.8% in March. Prior to March’s relapse, it had trended gradually up to 2.3% in February and January from a nine-month low of 1.6% in October. This is still markedly below the peak level of 2.9% in July 2005 (the highest level since December 2008). This would result in annual regular earnings growth remaining at 2.1% in the three months to April, after dipping to 2.1% in the three months to March from 2.2% in the three months to both February and January. It had recovered to 2.2% after relapsing to a low of 1.9% in the three months to November from a peak of 2.9% in the three months to July 2015.

Total average weekly earnings growth is expected to rise to 2.3% in April from 1.9% in March and a 13-month low of 1.3% in February. It had dropped to 1.3% in February from 2.7% in January. This series was affected by the timing of bonus payments in February/March. It is down from a peak of 3.6% in July 2015. This would still result in total annual earnings growth moderating to 1.8% in the three months to April (the lowest since the three months to February 2015) from 2.0% in the three months to March. It had been as high as 3.0% in the three months to both September and August 2015. This is the usual benchmark for earnings growth.

It is apparent that prolonged negligible inflation has been a significant factor in limiting pay awards, despite the fact that a tighter labour market had been expected to push up pay. It is also considered possible that annual earnings growth has been limited by a change in the mix of employment growth towards more lower-paid jobs.

With the labour market relatively tight, recruitment difficulties in some sectors and the National Living Wage taking effect in April, we think it is likely that earnings growth will gradually increase during the coming months; however, the pick-up does now look likely to be gradual in the near term at least.

Retail sales in May

Data out on Thursday are expected to show that retail sales volumes held up pretty well in May, growing by 0.4% month on month (m/m) after an increase of 1.3% in April; this would cause sales to be up 4.0% year on year (y/y) in May. April’s healthy increase in sales was at odds with pretty muted sales evidence for the month and it followed a dip of 0.5% m/m in March, although sales had risen by a very decent 0.8% quarter on quarter (q/q) in the first quarter.

Survey evidence for retail sales in May was pretty decent overall, with sales seemingly being helped by some warmer weather finally lifting demand for summer clothing and outdoor goods. Specifically, the British Retail Consortium (BRC) reported that retail sales values were up 1.4% y/y, having been flat y/y in both April and March. In volume terms, retail sales likely rose by around 3.0% y/y given that latest available data from the BRC show that shop prices were down 1.7% y/y in both April and March. Additionally, the Bank of England’s distributive trades survey showed the balance of retailers reporting a y/y increase in sales improved to +7% in May after slumping to -13% in April (the lowest balance since January 2012) from +7% in March, +10% in February, and +16% in January.

Relatively solid retail sales in May following April’s decent increase would reinforce hopes that GDP growth may be holding up better in the second quarter than had seemed likely. It had looked likely that GDP growth could slow to 0.2–0.3% q/q in the second quarter from 0.4% q/q in the first quarter and 0.6% q/q in the fourth quarter of 2015 amid heightened uncertainties ahead of the 23 June referendum. However, the possibility that GDP growth could hold up better than this has been lifted by industrial production surging 2.0% m/m in April, along with the 1.3% increase in retail sales.

It is likely that there will be some boost to retail sales in June from the European football championships, especially if the home countries do well. There will likely be some lift to retail sales from some people upgrading their TVs to fully enjoy the championships as well as from buying Euro 2016 souvenirs. The desire to upgrade TVs will also likely be boosted by the Olympics later this summer. There will also likely be a boost to alcohol and snack sales from people looking to enjoy matches at home. The better the home nation countries do, the greater the potential boost to the economy. If there are widespread early exits, there will be a large number of souvenirs and perhaps replica kits in the bargain buckets.

Nevertheless, we suspect that many consumers will be pretty cautious in their spending in the near term, particularly in the final run-up to the EU referendum. Indeed, consumer confidence weakened to a 16-month low in April before picking up slightly in May. It is also notable that the fundamentals for consumers have become less favourable recently. High and rising employment, together with decent purchasing power underpinned by negligible inflation, has been supportive of consumer spending.

The positive gap between earnings growth and consumer price inflation has essentially halved from the peak level seen in the third quarter of 2015, thereby diluting consumers’ purchasing power – although it is still decent. At 2.0% in the three months to March (the latest available data and the usual benchmark), annual average earnings growth was 1.5 percentage points above consumer price inflation of 0.5% in March (inflation dipped to 0.3% in April). In contrast, annual average earnings growth had been 3.0% in the three months to September 2015, when it was 3.1 percentage points above deflation of 0.1% that month. Additionally, the labour market has recently stuttered after sustained marked improvement, although employment was still at a record high in the three months to March.

Important for UK growth prospects is if reduced uncertainty after the June EU referendum (assuming there is a vote to stay) leads to a marked improvement in consumer confidence. There is the danger that consumer confidence remains pressured after the referendum because of recent weaker economic activity.

After the EU referendum (assuming there is a vote to stay), much will also obviously depend on how earnings growth develops, given that employers have been using prolonged negligible inflation as a reason to award modest pay increases. Also important is whether the labour market can regain momentum after the EU referendum. With the labour market relatively tight, recruitment difficulties in some sectors, and the National Living Wage taking effect in April, we think it is likely that earnings growth will gradually increase in the coming months.

Should the United Kingdom vote to leave the European Union in June’s referendum, the strong suspicion is that consumer spending would be severely pressured for some time as a consequence of increased uncertainty and likely higher unemployment. It is also very possible that purchasing power could be squeezed by inflation being pushed up markedly by a sharp fall in sterling.