Recent days have seen some key data releases and given a clearer picture of the road ahead for the UK economy. The recent European Central Bank (ECB) rate hike and the upward march in inflation over recent months had fuelled speculation about interest rate increases. Previously, the case for a May 2011 hike looked strong, provided Q1 activity rallied. This week’s economic data, however, appear to rule out such an early rise.
The latest inflation numbers brought some good news. Annual retail and consumer price inflation both fell back in March, after an unexpectedly sharp fall in food prices. But inflation remains well above the official 2% target and this downward trend may prove temporary, so this drop alone was unlikely to prevent the Monetary Policy Committee (MPC) following the ECB’s early move.
More decisive were weaker than expected demand numbers, reinforcing concerns about Q1 growth. The Office for National Statistics reported a fall in industrial production in February, while construction activity has yet to show a strong rebound after a very weak December and January. Consumer data are even gloomier, with confidence in the doldrums and the British Retail Consortium’s sales figures for March registering their worst monthly fall since records began in 1996. While Q1 preliminary GDP estimates on 27 April should still show some growth, we no longer expect a robust rebound from the surprise Q4 decline.
But it is only a matter of time before official rates move off their current lows. We now expect the MPC to delay its first 25 basis point rate hike until August. Its members can then ensure that demand has recovered in Q2 (preliminary GDP estimates are published in late July). This date would also coincide with the quarterly Inflation Report, allowing the Bank to explain the case for tightening in detail.
With the economy still fragile, any tightening will be cautious. Barring unexpected shocks, we anticipate just one further 25bp rate increase this year, coinciding with the November MPC meeting. This would leave official rates at only 1.0% by year-end. The pace of tightening is likely to pick up from 2012, however, unless inflation swiftly falls back to target. Here the response of wages to rising headline inflation will be critical and is likely to be the focus of intense MPC scrutiny over the coming months.