Fundamentals Economic and Investment Commentary March 2011 Mission improbable The UK is stuck at an impasse. Inflation is double the Bank of England’s target, yet economic growth has recently shifted into reverse. Higher interest rates are needed to cool rising prices and calm inflationary expectations. With government austerity measures being implemented at the same time, however, too large a response from the Monetary Policy Committee (MPC) could send the fragile UK recovery back into the depths of recession. Financial markets currently anticipate a series of interest rate increases throughout this year and into next year, expecting official interest rates to rise beyond 2%. In this edition of Fundamentals, Legal & General Investment Management’s economists James Carrick and Tim Drayson present an outlook for the UK economy and argue why the MPC is unlikely to raise rates as much as the market expects. Between a rate rise and a hard place energy prices and the continuing expectations of inflation to rise and feed Inflation is currently double the Bank of consequences of the fall in sterling through into wages and price-setting. England’s (BoE) 2% target and is likely to during 2008. While the MPC expects the This is particularly worrying since recent continue to rise to somewhere between temporary effects of these factors to economic data show the UK economy 4% and 5% over the next few months. wane, there is a great deal of uncertainty contracting 0.6% during the final three The MPC believes this primarily reflects about the medium-term outlook for months of 2010 – and that is before the the recent rise in VAT (Value Added Tax), inflation. There is a danger that as Government’s austerity measures have higher commodity prices, particularly elevated inflation persists, this could cause fully kicked-in. Inside: Market Overview Snapshot: US inflation – should we worry? UK Forecast: Underperformer 2 Legal & General Investment Management – March 2011 Article Contd. temporary. The impact on inflation from UK real consumer spending the rise in VAT will clearly not be repeated 7 r 6 again next year unless VAT is raised again. a e 5 y s 4 Also, energy prices will probably not rise u o 3 as rapidly unless crude oil prices spike 2 previ 1 n aggressively. Unfortunately, higher import o 0 -1 prices could become a more persistent ange -2 h -3 feature and should not be dismissed as c % -4 entirely driven by a one-off effect from the -5 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 earlier decline in sterling. The UK enjoyed Actual LGIM model - unchanged rates LGIM model - market rates a benign external environment during the Figure 1 Source: EcoWin, LGIM previous two decades. Import prices were Our model is based on our estimates for inputs ranging from employment, house prices, interest payments, lending standards, real wages and UK equities. kept low by a series of positive supply shocks from falling commodity prices through the This poses a dilemma for the MPC. Does it those consumers demand higher wages 1990s, the integration of many emerging try to promote more growth or act to curb to compensate for the erosion of real market economies into global trade and inflation? There is some disagreement on wages, the effect on inflation should be increased outsourcing of UK manufacturing. what it believes the best course of action only temporary (providing the source of Global price pressures to be. The minutes from the February the original price shock is not repeated). Some of the factors driving up commodity MPC meeting show that the committee Higher prices will reduce demand and prices are probably temporary in nature is split four ways. While three of the nine make it harder for companies to raise such as droughts in Russia last summer members believe interest rates should rise prices in the future. If, however, wages which pushed up food prices, but the global (with Andrew Sentance even calling for a also rise, companies are likely to increase economic environment is changing. There 0.5% increase), the majority support rates prices further to offset the cost of higher is increasing competition for resources remaining on hold for the moment, with labour costs. This process can become as countries such as China, India and one member – Adam Posen even voting self-reinforcing, creating structurally higher Brazil continue to grow far more rapidly for an additional injection of £50 billion in inflation (similar to the experience in the than the major developed economies. quantitative easing. This kind of divergence 1970s) with price increases driving higher The result of this dynamic is rising living within the MPC is extremely rare and shows wages, higher spending and even further standards in the emerging world and this how as the growth and inflation mix upward pressure on inflation. is creating greater demand for labour. deteriorates, policy-making becomes While we see very little evidence of wage Higher wages throughout these countries much harder. pressures at present, we do not entirely and a reluctance to use interest rates to Missing the target agree with the MPC’s assessment that the slow growth significantly mean that inflation The BoE’s monetary policy objective is factors currently boosting inflation are in the emerging world is likely to intensify. to deliver price stability, i.e. low inflation. Subject to that, it is to support the Mortgage split Government’s economic objectives for 1.0 growth and employment. Price stability is defined by the Government’s inflation 0.8 target of 2%. With the latest CPI (Consumer 0.6 Price Index) inflation reading of 4% (which is likely to rise further), inflation is set to be well 0.4 above its target for some time. The crucial 0.2 question, however, is whether the drivers Proportion of mortgage debt of higher prices are likely to persist or 0.0 ultimately subside. 01 02 03 04 05 06 07 08 09 10 11 12 fixed rate lending discount rate lending tracker Higher prices today mean less money capped SVR new flow SVR forced remortgage Figure 2 in UK consumers’ pockets – but unless Source: EcoWin, LGIM Legal & General Investment Management – March 2011 3 Article Contd. Crucially, we do not believe that the full Unemployment could hit 10% if rates rise impact of the announced government 12 austerity measures have fed through 11 to economic activity yet. GDP fell 0.6% 10 during the final quarter of 2010. While 9 part of this was due to disruptive cold % 8 7 weather in December, there was clearly 6 already a loss of momentum. January 5 retail sales recovered from the decline in 4 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 December, but the VAT increase could well take its toll over the next couple Actual LGIM constant rates LGIM market rates of months. Government investment Figure 3 Source: EcoWin, LGIM spending is scheduled to be cut sharply 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 and there are further tax rises due in Eventually we expect emerging market cuts to public sector employment planned April. However, the most pronounced exchange rates to rise to help combat for the new financial year, we believe even slowdown will come, we believe, inflationary pressure, but this will raise import with interest rates unchanged, consumer from local government activity. While prices to the UK even further. With the extent spending growth will ease through 2011 the fourth quarter of 2010 showed a to which UK retailers have outsourced and only begin to climb again during strong boost to government spending, production to these emerging markets, 2012. If rates were to increase in-line with this cannot be sustained. Once the there is very little room for local businesses market expectations, we estimate that real new financial year begins in April we to reduce the prices of their goods as input consumer spending would head back into anticipate that local government will costs move higher. negative territory during 2012 (Figure 1). begin to reduce workers in line with the spending cuts which have been Too much, too soon More sensitive to rate rises announced. There is not much the MPC can do about Households are more sensitive to an external price shocks, but the reason some increase in interest rates at the moment The combination of public sector job cuts, members want to increase official interest than in past years. The proportion of the persistence of high energy prices, tax rates is to contain inflation expectations and fixed-rate home loans (Figure 2) steadily rises and potentially higher interest rates in particular to prevent high commodity and increased up until 2007. Today, however, are likely to squeeze consumers’ spending import prices feeding through into wages. roughly 90% of mortgages are variable. If power, and increase unemployment So far there is no evidence of wages picking banks pass on any rate rises, which seems further this year. In fact, if the BoE were to up. While we sympathise with the view likely given pressure to rebuild capital levels, raise rates to the extent which the market that these global inflationary pressures are many homeowners will quickly experience has priced in, our model (Figure 3) shows building and unlikely to subside in the near a meaningful impact to their cash flow.