August Rate Cut is No Sure Thing

The outlook for the UK economy is fluid - terrorist events, major data revisions, the potential fallout from China's currency revaluation/currency regime change and even London's Olympic bid success all add a significant degree of uncertainty to the monetary policy outlook. At the close of an important week of UK data, the Bank of England's upcoming interest rate decision remains a finely balanced one. Whether they chose to keep rates on hold or cut rates at their 3rd/4th August meeting is very difficult to anticipate. On balance we still think the evidence favours an on hold' decision, but a rate cut would not be a surprise to us.

As close as it gets

Minutes to the July MPC (Monetary Policy Committee) meeting revealed a tight 5:4 vote to keep rates on hold. The closeness of the vote reflects how finely balanced the decision now is on the appropriate level of interest rates in the UK. The tone of the minutes reflects a great deal of uncertainty on the balance between demand and supply in the economy, on inflationary pressures and on the outlook for consumer spending. The August Inflation report (the analysis for which the MPC will have when they meet to decide interest rates in August) is when the Bank will try to make sense of the contradictory signs given by the recent substantial revisions to past UK economic data.

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If we do get a rate cut in August it is not sensible to assume that it is the first of several and that rates are rapidly heading down towards 4%. The fact that the July vote was so close suggests to us that the view that rates are definitely going to be cut significantly (by 50bp or more) over the remainder of this year makes things seem far clearer than is actually the case. There remains a strong case to be made that rates in the UK may not move far from current levels over the next year or so.

Recent data sends somewhat conflicting messages to the MPC. A surprisingly strong June retail sales number was followed by confirmation that Q2 saw another quarter of below-trend economic growth in the UK. Retail sales volumes grew 1.3% during June, following May's 0.0%. Earlier than usual discounting by retailers, and strong sales of summer clothes and sportswear, boosted the figures. Nevertheless, the data was a reminder that the UK consumer remains some way from collapse.

UK real GDP rose by 0.4% during 2005's second quarter and 1.7% compared to the same quarter of last year. This is significantly below the Bank of England's median projection for Q2 GDP growth of 2.5% year-on-year. This, however, is partly the result of recent revisions to past GDP data and although growth is lower than the BoE had projected, it is likely that the level of output is not. So the implications for inflationary pressure are not straightforward.

China's revaluation and recent terror events may yet impact the outlook. The likely impact of these developments is hard to discern at this stage. On balance, China's revaluation does not seem likely to have a large direct impact on the UK economy (the RMB, for example, has only a 3.5% weight in the Bank of England's sterling exchange rate index (ERI)).

However, were a significant RMB appreciation to emerge and be accompanied by a wider appreciation of Asian currencies against the dollar then, given that fundamentals suggest sterling should weaken against the dollar, that might be a trigger for significant falls in sterling. That would be welcome in terms of its impact on demand for UK goods overall and on the current account deficit, although the near-term inflationary impact would be less welcome.

The case for a rate cut is not clear cut

There are significant inflationary pressures in the economy. From 1.6% in January, CPI inflation is now at the Bank of England's 2.0% target. There is little to no spare capacity in the economy. Meanwhile, the sterling ERI has depreciated some 3% since the release of the Bank's last Inflation report on 11th May, the FTSE is up nearly 8% and the 2-year bond yield has fallen another 20bp. Growth has been below trend recently, but output levels have likely not been significantly below potential.

The consumer slowdown has materialised, but recent data support the view that we may already be through the worst. Further, with consumer debt at high levels, the housing market still probably overvalued and given inadequate savings, cutting interest rates would not necessarily be in the best medium term interests of the economy. Although we continue to think that the rate decision at the Bank's August meeting will be finely balanced, rate cuts are not a given and are not even the most likely outcome. Further, if the Bank were to cut rates in August, viewing this as the start of a series of rate cuts is not justified by the data.

By David Miles and Melanie Baker, Morgan Stanley EconomistAs published on the Global Economic Foru