Bank of England Monetary Policy Meeting Main Economic Feature of Week Beginning 1 June

The 3-4 June meeting of the Bank of England's Monetary Policy Committee (MPC) meeting seems unlikely to see any major policy developments, with interest rates remaining at 0.50% and the central bank pressing ahead with its Quantitative Easing programme that was extended by £50 billion to £125 billion at the May MPC meeting. While we strongly suspect that the Bank of England will end up further raising the amount that it is spending on Quantitative Easing, this seems unlikely to happen as soon as Thursday given that it was increased in May. Meanwhile, we expect interest rates to stay down at 0.50% deep into 2010.

Both the minutes of the May MPC meeting and the Bank of England's Quarterly Inflation Report for May hinted that the central bank is not yet done with monetary policy stimulus. Not only did the MPC vote 9-0 in favour of extending its Quantitative Easing programme at its May meeting, but the minutes reveal that some committee members believed that there was a case for a £75-billion increase rather than the £50-billion rise that was enacted. The MPC eventually agreed that there was no pressing need for the larger increase in May as it would take another three months to complete the £125 asset purchase programme and they can review the situation every month.

It is clear from both the May MPC minutes and the latest Bank of England Quarterly Inflation Report that the bank has major concerns and uncertainties about the strength and sustainability of any potential economic recovery. While acknowledging current "promising signs" that the rate of economic decline is moderating, Bank of England Governor Mervyn King has highlighted the major uncertainties surrounding the outlook, particularly given the ongoing need for financial institutions, households, and companies to adjust their balance sheets. Furthermore, the MPC has acknowledged that the 1.9% quarter-on-quarter decline in GDP in the first quarter was deeper than they had expected.

In addition, serious concern remains about the tightness of credit conditions, with latest data and survey evidence generally indicating that lending to companies and households has not picked up significantly so far. For example, the Bank of England's Trends in Lending report for May disappointingly showed that lending to corporates and households by the six major U.K. banks slowed in April after rising in March. It also reported that businesses continued to report higher spreads and fees on the renewal of credit facilities. This reinforces concerns that ongoing very tight credit conditions are a serious threat to economic recovery prospects.

Meanwhile, the Bank of England still believes that consumer price inflation is likely to undershoot its 2.0% target level on a two-year horizon, particularly given the amount of spare capacity in the economy. Critically, the central projections contained in the Bank of England's Quarterly Inflation Report for May showed that on the market assumption interest rates will start to rise gradually from the beginning of 2010 and Quantitative Easing amounts to £125 billion; consumer price inflation only rises from a forecast 0.5% in late-2009 to around 1.2% in two years' time. Even on the assumption that interest rates remain at 0.50% over the next two years while Quantitative Easing amounts to £125 billion, consumer price inflation is forecast to be just below the 2.0% target level on a two-year horizon.

The marked fall in consumer price inflation in April (from 2.9% to 2.3%, with core inflation dropping to 1.5%) and the recent significant firming of sterling will have done little to dispel the Bank of England's belief that consumer price inflation is likely to undershoot its 2.0% target level on a two-year horizon.

The MPC's 9-0 vote in favour of unchanged interest rates in May and the lack of any discussion about whether they should be moved at all reinforces belief that interest rates have highly likely troughed at 0.50%, but are not going to rise for some considerable time to come. This is not surprising given that the MPC has indicated in the past that they believe brining interest rates below 0.5% would have only a very limited positive impact at best, and could even be harmful. This is primarily due to the negative impact that this would have on bank's spreads and profitability, and hence potentially their lending. There is also a suspicion that a further interest rate cut would not be greatly passed on. Clearly, any further action by the Bank of England to boost economic activity will be centered on extending its Quantitative Easing programme.

We suspect that interest rates are set to stay at 0.50% deep into 2010, and we also believe that the quantitative easing programme will be extended further. The Bank of England currently has permission from the Chancellor to extend its quantitative easing programme by a further £25 billion to a total of £150 billion, but we believe that it may well eventually do more than this. Significantly, the minutes of the May MPC meeting concluded that "the risks of stimulating demand too little at the current time seemed greater than the risks of stimulating it too much." Furthermore, the minutes also reported that the MPC would ask Bank of England Governor Mervyn King to write to the Chancellor seeking an increase of the upper limit of £150 billion for the Quantitative Easing programme "should economic conditions require it."

MAIN ECONOMIC DATA RELEASES

The May manufacturing purchasing managers' index (PMI—out on Monday) is expected to show that the rate of contraction in the sector is continuing to moderate from the very deep levels seen in the latter months of 2008 and early in 2009, helped by the major de-stocking that has now occurred. There are also signs that sterling's substantial overall depreciation is providing limited increased support to foreign orders. Specifically, we forecast the manufacturing PMI to have climbed to a nine-month high of 43.9 in May from 42.9 in April and 34.9 in February. Nevertheless, this would still indicate significant contraction, given that a reading of 50.0 denotes unchanged activity. Manufacturers are still battling against depressed domestic demand, contracting activity in key export markets, intensified competition, worsened cash flows, and very tight credit conditions.

The Bank of England is expected to report on Tuesday that mortgage approvals for house purchases rose to 41,000 in April from 39,230 in March and a record low of 27,227 in November 2008. There is mounting evidence that house price activity has passed its low point and is picking up to a limited extent in response to the substantial fall in house prices from their 2007 peak levels and markedly reduced mortgage rates. Even so, this would still be a very low level of mortgage approvals compared to long-term norms. Indeed, mortgage approvals averaged 98,000 a month between 1993 and 2007. In addition, the Bank of England is forecast to report that net mortgage lending amounted to £1.0 billion in April. This would be up only marginally from £757 million in March and below the average of £1.2 billion for the previous six months. It would be down massively from £5.6 billion in April 2008. This reflects the weakness of past mortgage approvals and it is current mortgage approval levels that are seen as the key forward-looking indicator for housing market activity.

Meanwhile, the Halifax lender is forecast to report during the week that house prices fell at a markedly reduced rate of 0.5% month-on-month in May, which would be down from declines of 1.7% in April and 1.9% in March. This would cause the year-on-year fall in house prices to moderate to 17.1% in the three months to May from 17.7% in the three months to April. The year-on-year drop in house prices would ease to 16.3% in May itself from 17.7% in April. Admittedly, there is massive uncertainty over this forecast following the Nationwide lender surprisingly reporting that house prices rose 1.2% month-on-month in May.

While we suspect that housing market activity has passed its low point, we expect that the pick up in activity will be both gradual and fitful given ongoing very poor economic fundamentals and still-tight credit conditions. Consequently, we believe that house prices will fall significantly further, although we do expect the rate of decline to moderate gradually over the coming months. We also expect to see increasing volatility in house prices. Specifically, we forecast house prices to fall by another 12% from their current levels to bottom out around mid-2010.

The Bank of England is also forecast to report on Tuesday that net consumer credit amounted to just £0.1 billion in April, as it did in March. Consumer credit is likely to be limited over the coming months by still very tight-lending conditions, as well as many people increasingly looking to rein in their borrowing. Elevated debt levels, historically low household savings rates and sharply lower house prices mean that there is a pressing need for many consumers to improve their balance sheets. Furthermore, we suspect that very serious concerns over jobs, the economic outlook, and their pensions will cause many people to try to save more, if they can. Higher distressed borrowing seems certain over the coming months (if people can get it), as an increasing number of households struggle in the face of markedly higher unemployment and heightened pressures on their finances.

The construction purchasing managers index (PMI—out on Tuesday) is forecast to have shown further limited improvement in May having risen in March and, especially, April from February's record low. We expect the PMI to have climbed to a nine-month high of 39.0 in May from 38.1 in April, 30.9 in March and an all-time low of 27.8 in February (the series started in 1997). Even so, this would still be substantially below the 50.0 level that indicates unchanged activity.

The construction sector is being helped to a limited extent by the government bringing forward some infrastructure spending as part of its efforts to boost the economy. There are also growing signs that housing market activity has passed its low point. With the housing market and commercial property sectors still under serious downward pressure, it is hard seeing the sector returning to growth any time soon. The latest national accounts data show that construction output plunged 2.4% quarter-on-quarter and 8.6% year-on-year in the first quarter of 2009, which was the fourth successive quarter-on-quarter drop.

The service sector purchasing managers' index (out on Wednesday) is forecast to show that the rate of decline in the dominant sector was similar in May to the much reduced rate seen in April. Specifically, we expect the business activity index to have edged up to a nine-month high of 48.9 in May after jumping to 48.7 in April from 45.5 in March. This would be very close to the critical 50.0 level that indicates unchanged activity, thereby indicating that the sector is close to stabilizing after a year of contraction. Even so, the services sector is still under serious pressure from muted consumer spending on services, reduced business spending, still serious financial sector problems, and limited housing market activity.

Producer price data for May (out Friday) should provide further evidence of manufacturers' markedly reduced pricing power in the face of recent extended sharply contracting activity and orders. Specifically, we expect headline annual producer output prices to have risen 0.3% month-on-month in May, thereby causing prices to have fallen 0.5% year-on-year. This would compare to year-on-year increases of 1.2% in April and a record peak of 10.0% in July 2008. Core output prices are also forecast to have risen 0.3% month-on-month in May. This would bring the year-on-year increase down to 1.2% in May from 2.4% in April and a peak of 6.3% in July 2008. Meanwhile, the consensus is for producer input prices to have risen 0.7% month-on-month in May, as oil prices rose further from their lows earlier in the year and the weak pound pushed up the prices of some imported raw materials and commodities. Nevertheless, producer input prices are seen falling 8.3% year-on-year in May, in marked contrast to the record rise of 34.1% seen in June 2008.

By Howard Archer