The inconvenient truth the MPC can't ignore

The Bank of England appears to be unhappy with data produced by the Office for National Statistics. As the MPC meets to set interest rates this week, could there be trouble ahead?

It's all happening in Wales these days. Not only did the recent local election results reveal the Conservative Party gaining a seat in Rhondda Cynon Taff for the first time (!) but perhaps more importantly, from the perspective of the UK economy, the recently relocated Office for National Statistics (ONS) has come under the microscope for what could prove important errors in key data releases.

We are hugely indebted to our former colleague Stuart Thomson for pulling up a few floorboards and reminding us that just a couple of years ago the Bank of England itself was warning that the decision to move the Office to Wales might seriously undermine the quality of the statistics it produces (key staff departures).

At the time few paid much attention, but back then the economy was growing strongly, inflation was in its box, employment prospects were positive and the housing market was blazing away as consumers gorged on debt. Now prospects look much less rosy and the Bank needs reliable data on which it can base its conclusions on the outlook for spare capacity and, by extension, inflation.

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General consensus amongst independent economists has it that UK base rates may be cut to 4.5% by the end of 2008 but that the reemergence of near-term inflationary pressure should ensure that any further monetary easing is very much loaded towards the back end of the year. The Monetary Policy Committee (MPC) has already stated that it will not cut domestic base rates again while inflation continues to bump against, or even over, the top end of the envisaged 1-3% range on the targeted measure.

At the same time, futures pricing even goes so far as to suggest that the UK might have to suffer a 0.25% point rate hike before the year-end! The basis of this discrepancy is not, actually, inflationary pressure so much as deep uncertainty surrounding the pace of future growth.

The basis for the assertion that it is the outlook for growth and not the outlook for inflation that currently rattles the MPC's cage can be derived from Bank governor Mr Mervyn King's comments to accompany May's decision to keep the UK's base rate on hold at 5.0%. At that point Mr King stated that "It was not appropriate to bring inflation back down to target quickly since this risked undesirable volatility in output and as such the MPC is looking to drive inflation back to target over a somewhat longer time horizon".

The case for lower base rates rests on the central bank's expectation that inflation will gradually return to the middle of its envisaged band by the end of the two year forecasting horizon, as base effects improve and sub-trend growth creates excess spare capacity which, it hopes, should ensure that the genie is popped neatly back in the bottle.

This cosy scenario is, however, predicated on the basis that the statistics upon which forecasts are made are reliable and not as vulnerable to shifting as the sands of the Severn estuary. The root of the problem lies in the fact that the Bank's own economic data is at odds with those releases from the ONS. In such circumstances it is natural for the former to accuse the latter of some shakiness.

The MPC is forecasting, based on the strength of received data, that domestic activity will trough in spring 2009 at an annualised rate of just 1.0%. This, in turn, is based on the expectation that base rates would be cut further, a view widely held until the recent surge in inflationary pressure asserted its vice-like grip on central bankers' collective consciences.

This is why the August Quarterly Inflation Report is likely to make such interesting reading. By that stage the Bank will have had to have revised its inflation expectations based on base rates that are likely to remain higher than was perhaps originally intended by that stage, coupled with a Libor rate that steadfastly remains above base as credit concerns, although abating, continue to cast a residual shadow.

At this stage the combination of higher inflation, sticky inter-bank rates and higher than expected base rates leaves growth forecasts under pressure and in danger. Starting from an already low level of forecast growth, the risk must now be that the UK economy will do very well to hold above zero and head off recession.

Furthermore, the previously envisaged speedy return to trend envisaged beyond 2009 must be cast in even further doubt. We recently remarked that far from anticipating a "V" shaped recovery investors should be thinking in terms of a long hard crawl back from the abyss. In the light of recent data releases we feel more convinced than ever of the accuracy of this view.

The Bank's job is made more difficult by the fact that its specific remit, to bear down on inflationary pressure, means that furtively changing tack and setting monetary policy based on expectations for growth relies more on a response to existing weakness than a pre-emptive strike against future weakness.

We strongly suspect that dissenting MPC member Mr David Blanchflower is right to voice his concerns regarding the risks associated with doing nothing. It is equally unsurprising that the majority on the Committee are unprepared to put the Bank's reputation on the line again, so soon after its starring role in the Northern Rock debacle.

Even if the Bank were prepared to think the unthinkable we suspect that it would be stymied by its lack of confidence in the data emanating from the landscaped gardens on the fringes of Newport. This now takes on critical significance. The Bank has for some time questioned the validity of gross domestic product (GDP) data emanating from the ONS which, its own sources indicate, has routinely under-estimated initial estimates of quarterly growth.

Stung by this criticism the ONS, either wittingly or unwittingly, appears to have overcorrected. The preliminary (second) estimate of Q1 2008 GDP emerged at 0.4%, however, this figure was based upon and dominated by a 1.3% increase in consumer expenditure as business investment and inventory levels subsided. This surge in consumer expenditure was based, in turn, on far from likely strength in retail sales and the service sector.

The Bank's own data suggests that consumer spending was, in fact, much weaker than the ONS data indicates, with three month growth to April of just 0.5%, against the ONS +1.5% growth "confirmed" in official retail sales data. Equally, the ONS data indicates that service sector expenditure grew by 0.5% in March following an upward revision to +0.4% in February.

Over the same period the more reliable data from the Confederation of British Industry (CBI) suggests that companies actually reported their single largest quarterly fall in activity over Q1 2008 since 2001. We accept that the two organisations collect data very differently (the CBI qualitatively and the ONS quantitatively) but the wide discrepancy between the two is hardly likely to fill monetary policy makers with confidence, particularly given the critical nature and timing of their next active decision.

On 5th June the Bank's Monetary Policy Committee members will pronounce on UK base rates at midday. The strong consensus is that domestic base rates will be kept on hold. The Bank will cite prevailing inflationary pressures as the justification for its decision and industry interest groups will wring their collective hands as activity capitulates. The lack of faith in the data on which critical decisions are having to be made has exacerbated the built-in caution inherent in central bankers' mind sets. Consequent lack of visibility has inevitably caused the drivers of monetary policy to slow the pace of policy action.

Given the price for getting it wrong, an economic recession in 2009 and an unpleasant convergence of the economic and political cycles, the outlook is indeed grim and we add our name to the growing list of those who increasingly think that a domestic recession lies at the bottom of this greasy pole.

From the 'Week in Preview' newsletter published by Charles Stanley Stockbrokers