Waiting For The Day

We've reached a critical point in the UK interest rate debate. After a first half of the year which was characterised by dramatic swings in the market's interest rate expectations, financial markets now believe that the point of MPC action is at hand. The consensus says that the Bank of England will lower the repo rate to 4.50% in August then to 4.25% in November.

Our own view is that we'll still have to wait until November for the first move. The latest views of the MPC will be available on Wednesday with the publication of the minutes of the July policy meeting. Unless these minutes act to reign in market expectations we can probably assume that our timing is wrong and that rates will be lowered a fortnight later.

Of course, from the economy's perspective, a month or two here or there doesn't matter very much. Timing is important, however, to the market's perception of where the UK economy sits in the cycle and the consequence for rate policy further out. The delivery of an August cut endorses the market's new-found view that the fundamentals of the UK economy have shifted materially over recent months to the extent that the Bank of England has been shocked into action. Such a move would likely result in a yet more aggressive easing profile being reflected in the curve, with the Bank seen embarking on a rescue operation to save the UK consumer.

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But as we've been stressing over the past few weeks, there has, in our view, been an overreaction to economic newsflow in the UK, with the greater likelihood being that the majority of the MPC still want to wait and see. Our case is based upon the notion that the overall weakness in consumption has been distorted by a sharp drop in spending on durable goods. Consumption of services by the personal sector is still running at respectable rates of growth. The current downturn still compares favourably with the more dramatic setback suffered in the early 1990s. As Mervyn King has pointed out recently, the resilience of services consumption might suggest some correction in spending on durables is likely in the coming months. Indeed, as recent retail sales data have shown, the steady rise in household mortgage growth has once again provided a reliable indicator of spending on household goods, which has been on an improving trend since March.

Of course, we are still bearish on the UK consumer for the coming year as a whole, as the pressure from an easing labour market gets exacerbated by tighter fiscal policy. But for the time being it still seems to us that solid household income growth will deliver a somewhat better than expected second half of this year than is currently priced in to the market

By Steven Andrew,Economist, F&C