Edging towards an interest rate cut - Capital Economics
UK Economics

Edging towards an interest rate cut

UK Economics Weekly
Written by Ruth Gregory

Chancellor Sajid Javid’s new fiscal rules clear the way for a big splurge in investment spending. And the fiscal loosening would probably be even larger if the Labour Party were to win the election. The flipside of this big fiscal loosening is that monetary policy may need to be tighter than might otherwise have been the case. But the Bank of England this week sounded far less convinced that interest rates would be raised, even if there were a “clean” Brexit deal. We have pencilled in a rate cut in May 2020 in our repeated delays Brexit scenario, but the risk is that it could now come sooner. Further ahead, though, a “clean” Brexit deal and a fiscal boost could mean that rates ultimately rise further than the markets expect.

The policy debate has shifted this week to just how large a fiscal stimulus is in prospect and whether the Monetary Policy Committee (MPC) might soon cut interest rates.

We warned this would happen. We were the only ones to predict that any MPC members would vote for a 25bp interest rate cut on Thursday. (See here.) In the event, two members voted for a cut. And our predictions for the revamped new fiscal rules outlined by the Chancellor, Sajid Javid, were bang on the money too. (See here.) Hopefully this makes up for incorrectly predicting that England would win the Rugby World Cup! (See here.)

As a result of Javid’s new fiscal framework, if the Conservatives were to win the election the Party could announce an increase in investment spending to the tune of about £22bn per annum (1.0% of GDP). That boost would be even bigger with Labour at the helm following its announcement on Thursday that it would scrap its “Fiscal Credibility Rule” and increase investment spending by about £55bn a year (or 2.5% of GDP). We will won’t find out the detailed spending pledges until the election manifestos are published in the next few weeks. But the main point is that, whatever the election result, a very large fiscal boost is on the way. (See here.)

The flipside of this big fiscal loosening is that monetary policy may need to be tighter than might otherwise have been the case. Admittedly, the Bank of England sounded far less convinced that interest rates would be raised – even on the basis of its forecasts for a “clean” Brexit deal, or in Bank speak an “orderly transition to a deep free trade agreement”. Indeed, it softened its guidance by adding the word “modest” to its well-worn phrase that a “gradual and limited” tightening of monetary policy may still be needed. (See here.)

But it is worth noting that a possible fiscal stimulus of up to a whopping 2.5% of GDP per annum is not included in the Bank’s forecast. If it had been, the Bank of England would surely have been signalling more clearly in its deal forecasts that it intends to hike rates at least once over the next few years.

Of course, if the fiscal stimulus does not materialise and/or there isn’t a “clean” Brexit deal (i.e. uncertainty prevails), then rate cuts are probably in order. And the MPC sent its strongest signal yet in this week’s Monetary Policy Report (the new name for the old Inflation Report) that it might have to reduce rates if Brexit uncertainty drags on or global growth fails to recover.

And following Boris Johnson’s suggestion that the government might not extend the transition period beyond December 2020, there is surely a real risk that Brexit uncertainty does last for longer. (See here.) That would mean that if the UK has not agreed on its future trading arrangements with the EU by that point, then the UK would start trading with the EU on something similar to WTO rules. And if businesses and households were to fear this outcome then business investment may fail to recover and households could remain reticent about spending.

And if the outcome of the election is an unstable government with a slim or no majority then the politicians may not be able to implement a big fiscal boost and Brexit would probably be delayed further.

Overall, we have pencilled in a rate cut in May 2020 in our repeated delays Brexit scenario but the risk is that it could now come sooner, perhaps even before Brexit. Further ahead, though, if there is a “clean” Brexit deal and a fiscal boost, interest rates may ultimately rise further than the markets expect.

Week ahead

The labour market figures published on Tuesday are the major data release to look out for next week. If employment fell in September as we expect, that could add to the growing concerns on the MPC about the softening labour market. Meanwhile, we expect a rise of 0.5% q/q in GDP in the Q3 figures released on Monday. But just as the fall in GDP in Q2 overplayed the weakness of the economy, the rise in Q3 will probably overplay the strength.


Data Previews

GDP (Sep./Q3) & International Trade (Sep.) Mon. 11th Nov.

Forecasts

Time (GMT)

Previous

Consensus

Capital Economics

Quarterly GDP q/q(y/y)

09.30

-0.2%(+1.3%)

+0.4%(+1.1%)

+0.5%(+1.2%)

Monthly GDP m/m(3m/3m)

09.30

-0.1%(+0.3%)

-0.2%(+0.4%)

0.0%(+0.5%)

Trade in Goods & Services Balance

09.30

-£1.5bn

-£2.0bn

-£2.0bn

Q3 bump will give way to modest Q4

Just as the 0.2% q/q fall in GDP in Q2 overplayed the weakness of the economy, our estimate of a 0.5% q/q rise in Q3 would overplay the strength.

The monthly GDP figures for July and August suggest that GDP in Q3 as a whole probably rose by either 0.4% q/q or 0.5% q/q. Our calculations suggest that even if industrial production fell by 0.2% m/m in September, construction dropped by 1.0% m/m and services output managed a 0.1% m/m rise, stable GDP in September would be enough to generate a 0.5% q/q gain. (See Chart 1.) We estimate that net trade made a broadly neutral contribution to growth in Q3 (although the trade deficit may have widened from £1.5bn in August to £2.0bn in September), consumption rose by 0.4% q/q and that the previous 31st October Brexit deadline resulted in rises in government spending, stockbuilding and business investment. Unfortunately, it looks as though GDP growth may ease back to around 0.2% q/q in Q4.

Chart 1: GDP

Sources: Refinitiv, Capital Economics

Labour Market (Sep.) Tue. 12th Nov.

Forecasts

Time (GMT)

Previous

Consensus

Capital Economics

ILO Unemployment Rate (%)

09.30

3.9%

3.9%

3.9%

Average Earnings m/m(% y/y of 3m av.)

09.30

+0.2%(+3.8%)

(+3.8%)

+0.4%(+3.8%)

Deterioration in the labour market vindicates MPC dissenters

We suspect employment fell by substantially more than the consensus forecast in September. While that might not have been enough to nudge the unemployment rate up from 3.9% to 4.0%, it would vindicate the two MPC members that voted for a cut because the “labour market is turning”.

The single month figures show sharp falls in employment in the July and August survey cohorts. We suspect that deterioration continued in September, causing employment to fall by around 140,000 in Q3 (the consensus forecast is 109,000).

The fall in employment in August was concentrated among younger workers which some argue is volatile. But it has been sustained for some time. (See Chart 2.) And the employment PMI also points to a marked slowdown in employment growth.

Pay growth probably held steady at 3.8% in September, but may moderate next year. The softening labour market means that unless the economy gets a kick from a Brexit resolution, more MPC members may vote for rate cuts ahead.

Chart 2: Employment by Age Group (000s, 3m/3m)

Sources: Refinitiv, Capital Economics

Consumer Prices (Oct.) Wed. 13th Nov.

Forecasts

Time (GMT)

Previous

Consensus

Capital Economics

Consumer Prices m/m(y/y)

09.30

+0.1%(+1.7%)

+0.1%(+1.7%)

-0.1%(+1.5%)

Core Consumer Prices m/m(y/y)

09.30

+0.2%(+1.7%)

(+1.7%)

+0.1%(+1.8%)

Inflation to fall further below the 2% target

While we think that core inflation ticked up from 1.7% to 1.8% in October, a fall in utility bills probably pushed overall inflation further below the MPC’s 2% target, perhaps to 1.5%.

The contribution of energy prices to CPI inflation probably fell in October. Ofgem lowered its cap on utility firms’ standard variable tariffs on 1st October. That is likely to have caused utilities CPI to fall by 6% m/m in October, subtracting 0.25ppts from inflation. (See Chart 3.) What’s more, prices at the fuel pumps dropped by 0.4% m/m, compared with a 0.7% m/m rise in October 2018, subtracting a further 0.03ppts from inflation. Other factors could partially offset these effects. Clothing prices probably rose by about 0.5% m/m, well above last October’s unusually weak reading of -0.6% m/m. That could add 0.1ppts to CPI inflation.

All told, CPI inflation is likely to have fallen in October, perhaps from 1.7% to 1.5%. And for as long as Brexit is delayed, we think firms will absorb higher costs in their margins rather than pass them on to customers in the form of higher prices, leaving inflation below the 2% target.

Chart 3: Contribution of Utilities to CPI Inflation (ppts)

Sources: Refinitiv, Capital Economics

Retail Sales (Oct.) Thu. 14th Nov.

Forecasts

Time (GMT)

Previous

Consensus

Capital Economics

Retail Sales Volumes (Including Petrol)

09.30

0.0%(+3.1%)

+0.3%(+3.7%)

0.0%(+3.5%)

Sales probably unchanged, despite weak survey data

Retail sales volumes were probably unchanged in October after edging up slightly in September, despite the weak survey data suggesting otherwise.

The various measures of retail sales have painted a fairly downbeat picture recently. The CBI’s “sales for the time of year” indicator points to a drop in annual sales growth from 3.1% in September to about 2.0% in October. The BRC’s like-for-like sales volume measure paints a similar picture. (See Chart 4.)

Meanwhile, although the month of October was colder and wetter than usual (the average temperature was 0.8 degrees below its post-1970 average for October), weather effects usually cancel each other out – helping some sectors (such as department stores) but hurting others (such as food stores).

But the CBI and BRC indicators of retail sales have overstated the weakness in the official data recently. And with wage and jobs growth remaining resilient, we doubt sales fell in October. As a result, we think sales volumes remained unchanged prompting a pick up in the annual rate from 3.1% to 3.5%.

Chart 4: Official Retail Sales & BRC Retail Sales

Sources: BRC, Refinitiv, Capital Economics


Economic Diary & Forecasts

Upcoming Events & Data Releases

Date

Country

Release/Indicator/Event

Time (GMT)

Previous*

Consensus*

CE Forecasts*

UK Data Response

Mon 11th

UK

GDP (Q3, Prov., q/q(y/y))

(09.30)

-0.2%(+1.3%)

+0.4%(+1.1%)

+0.5%(+1.2%)

DR

UK

GDP (Sep, m/m(3m/3m))

(09.30)

-0.1%(+0.3%)

-0.2%(+0.4%)

0.0%(+0.5%)

DR

UK

Services Output (Sep, m/m(3m/3m))

(09.30)

0.0%(+0.4%)

+0.1%(+0.4%)

+0.1%(+0.5%)

DR

UK

Industrial Production (Sep)

(09.30)

-0.6%(-1.8%)

+0.1%(-1.1%)

-0.2%(-1.2%)

DR

UK

Manufacturing Output (Sep)

(09.30)

-0.7%(-1.7%)

+0.1%(-0.3%)

-0.7%(-2.2%)

DR

UK

Construction Output (Sep)

(09.30)

+0.2%(+2.4%)

-0.2%(+1.2%)

-1.0%(+0.3%)

DR

UK

Trade Balance (Sep)

(09.30)

-£1.5bn

-£2.0bn

-£2.0bn

DR

Tue 12th

UK

Change in Employment (Sep, 3m/3m)

(09.30)

-56,000

-109,000

-140,000

DR

UK

ILO Unemployment Rate (Sep)

(09.30)

3.9%

3.9%

3.9%

DR

UK

Average Earnings Inc. Bonus (Sep, m/m(3m/yy)

(09.30)

+0.2%(+3.8%)

(+3.8%)

+0.4%(+3.8%)

DR

UK

Average Earnings Ex. Bonus (Sep, m/m(3m/yy))

(09.30)

+0.4%(+3.8%)

(+3.8%)

+0.3%(+3.8%)

DR

UK

Productivity (Q3, Prov.)

(09.30)

-0.2%(-0.5%)

(-0.5%)

DR

Wed 13th

UK

CPI (Oct)

(09.30)

+0.1%(+1.7%)

+0.1%(+1.7%)

-0.1%(+1.5%)

DR

UK

Core CPI (Oct)

(09.30)

+0.2%(+1.7%)

(+1.7%)

+0.1%(+1.8%)

DR

UK

CPIH (Oct)

(09.30)

+0.1%(+1.7%)

(+1.8%)

0.0%(+1.6%)

DR

UK

RPI (Oct)

(09.30)

-0.2%(+2.4%)

+0.1%(+2.3%)

-0.1%(+2.2%)

DR

UK

PPI Input (Oct)

(09.30)

-0.8%(-2.8%)

-0.8%(-4.5%)

DR

UK

PPI Output (Oct)

(09.30)

-0.1%(+1.2%)

+0.1%(+1.0%)

+0.1%(+0.9%)

DR

UK

House Price Index (Sep)

(09.30)

(+1.3%)

Thu 14th

UK

RICS Past House Price Balance (Oct)

(00.01)

-2%

-2%

UK

Retail Sales Inc. Fuel (Oct)

(09.30)

0.0%(+3.1%)

+0.3%(+3.7%)

0.0%(+3.5%)

DR

Fri 15th

No Significant Data Released

Selected future data releases and events

Thu 21st

UK

Public Finances (Oct)

(09.30)

DR

*m/m(y/y) unless otherwise stated

Sources: Bloomberg, Capital Economics

Main Economic & Market Forecasts**

%q/q(%y/y) unless stated

Latest

Q1 2019

Q2 2019

Q3 2019

Q4 2019

2019

2020

2021

GDP

-0.2(+1.3)

+0.6(+2.1)

-0.2(+1.3)

+0.5(+1.2)

+0.2(+1.0)

(+1.4)

(+1.0)

(+1.5)

Household spending

+0.4(+1.1)

+0.3(+1.3)

+0.4(+1.1)

+0.4(+1.2)

+0.4(+1.4)

(+1.3)

(+1.6)

(+1.6)

CPI inflation (%)

(+1.7) (Sep)

(+1.9)

(+2.0)

(+1.8)

(+1.6)

(+1.8)

(+1.7)

(+1.7)

ILO unemployment rate (%)

3.9 (Aug)

3.8

3.9

3.9

3.9

3.9

3.9

3.9

Bank rate, end period (%)

0.75

0.75

0.75

0.75

0.75

0.75

0.50

0.50

10 yr gilt, end period (%)

0.78

1.00

0.83

0.49

0.75

0.75

0.75

0.75

$/£, end period

1.28

1.32

1.27

1.23

1.25

1.25

1.25

1.25

Euro/£, end period

1.16

1.17

1.12

1.13

1.14

1.14

1.14

1.14

Sources: Capital Economics, Refinitiv

** Based on a scenario in which Brexit is repeatedly delayed. For more see our UK Economics Update Two small forecast tweaks”, 5th November 2019.


Ruth Gregory, Senior UK Economist, +44 20 7811 3913, ruth.gregory@capitaleconomics.com