HSBC Monthly economic commentary - June 2010

Monetary policy takes a back seat

With the current focus on the government's steps to reduce the budget deficit, monetary policy has taken a back seat to fiscal policy since the election. The first spending cuts, amounting to £6 billion have already been announced, a Budget has been set for June 22nd which will contain more far-reaching measures and a spending review is promised for October. Not surprisingly, Bank Rate was left on hold at the June meeting of the MPC, and is likely to stay at 0.5% for the rest of 2010.

To keep the cost of debt-servicing manageable, the UK needs to retain its 'Triple-A' credit rating. A downgrade of the rating will push up government borrowing costs and the rating agencies have supported Chancellor Osborne's view that without immediate action, the status would be at risk. But, as fiscal policy is tightened, the risk of weaker activity in the domestic economy increases. Keeping Bank Rate at its current 0.5% will help to offset cuts in government spending. The risks – that growth falters, that inflation returns, or that the euro contagion spreads – remain, and the MPC decision to sit tight was the obvious one.

Two steps forward …

As happens so often in the recovery phase of a cycle, good news mingles with bad, but the balance continues to point to a slow, upward movement in activity. Official retail sales figures in April were stronger than expected, and there seems to have been less price discounting to achieve volume growth. Mortgage approvals continued to creep up in April, still well below the pre-2008 levels but at least the movement is now in a positive direction. Consumer credit remains subdued, with debt repayment a higher priority than new borrowing. New car registrations in May were 13.5% up on the year, the 11th consecutive monthly increase, but this partly reflects the weakness of last year's sales.

The closely-watched monthly PMI surveys are again showing more optimism about the short-term outlook than the latest official data. In the services and construction sectors, the headline balances are both again above 50, pointing to expansion, while manufacturing's 58 is the highest for 15 years. Manufacturing seems to be the most vibrant sector, with strong output growth being accompanied by improved export orders. The first rise in business investment for two years was reported in Q1 this year – a modest 6%, but a step in the right direction of rebalancing the economy.

Labour market data highlight the general sense of ambiguity: claimant unemployment was better than expected in April (down by 27,100), but the Labour Force Survey (a measure of those looking for work but not necessarily claiming benefits) reported a 53,000 rise in the three months to March. The number of people in work, moreover, was 76,000 lower in the same period. Annual pay (excluding bonuses) was still under 2% and suggests a lot of slack in the labour market.

 … but one step back

There was even some good news on public sector finances, with the 2009-10 deficit (originally projected at £168 billion) revised down to £145.4 billion). But the net borrowing in April of £10 billion was the highest April figure on record and the ratio of debt to national income edged up 62%. And it is the continuing uncertainty about public finances that is the single biggest area of concern about the economy at the moment.

It is the government's intention to cut public spending by £4 for every additional £1 they raise in taxes. Welcome as this balance might appear, it begs many questions which are creating uncertainty. The employment implications of the spending cuts, the regional distribution of the pain, the sectoral allocation, and so on, all need to be resolved. And where the inevitable tax increases over and above those already announced will fall is having an influence on spending and investment decisions as well as confidence levels. The situation is not helped by policymakers talking the economy down and the extent of the cuts up. It may be part of a softening up process, it may be an attempt to use the deficit as an excuse to introduce politically motivated changes in the public sector, it may be a desire to make things seem worse so that when they improve faster the policymakers can take more credit than they are entitled to, or the claims may well be true, but the short-term impact is damaging. This budget matters more than most for many years.

Europe remains a potential problem on several fronts, not least the UK's ability to export its way to sustained growth. The general picture remains murky with a bias to a further deterioration. If the worst predictions of the debt problem are borne out, it will affect the functioning of financial services as well as the growth outlook.

The elephant in the room

Despite the fragility of the recovery, the annual rate of consumer price inflation in April rose to 3.7% in April according to the CPI, while the RPI measure (5.3%) was the highest since July 1991. There are mitigating circumstances, such as the re-imposition of the 2.5% VAT reduction, a jump in oil prices and the impact of a weaker exchange rate on the cost of imports. These 'temporary' factors have allowed the MPC to keep interest rates at their current historically low rates for over a year, but the view is gaining ground that inflation rather than growth or deflation is the issue that needs to be addressed, and to be tackled before it takes a hold.

Given the likely scale of fiscal tightening and the slow pace of recovery, raising interest rates now would virtually guarantee a 'double dip' recession. Even if the CPI is outside the target range, neither the Treasury nor the MPC will want to see Bank Rate increase. The Bank Governor has said the MPC will 'look through' the current rise in prices, forecasting that inflation will fall back later in the year. The longer the CPI stays outside the target range, however, the harder it may be to hold this line.

There also needs to be a debate about how inflation should be measured (with or without house prices) and whether the target should be broader than just inflation (to include jobs and growth as well for example). There is, however, a feeling that to change now would damage the credibility of the policy and policymakers, and that the MPC should stick with a single measure, clearly defined, easily understood and which is consistent with the recent past.

Conclusion

Monetary policy will continue to be a sideshow while restructuring the fiscal mess takes centre stage. At some stage, the stimuli introduced by the previous government will have to be reversed and the most likely sequence is fiscal policy, QE and then monetary policy. As spending is reduced and taxes increased, low interest rates will continue to be the policy tool that supports expansion.

After a 5% fall in GDP last year, growth in 2010 is likely to be positive, around the 1.5% as Alistair Darling predicted in his final budget. His view of 2011 (growth in excess of 3%) is now widely viewed as too optimistic, reflecting the need to unwind consumer debt, the effects of a tougher fiscal stance, weak growth in Europe and uncertainty in the labour market. But inflation could yet lead to a re-assessment of prospects for the next 18 months.

Dennis Turner Chief Economist, HSBC Bank plc 11 June 2010