Bank of England Monetary Policy Meeting Key U.K. Economic Event for Week Beginning 4 May

It seems a stone dead certainty that the Bank of England will leave interest rates unchanged at a record low of 0.50% at the May 6-7 meeting of its Monetary Policy Committee (MPC). Indeed, interest rates seem likely to remain at 0.50% deep into 2010. The Bank of England is now very much focusing on Quantitative Easing in its attempts to counter still very tight credit conditions and boost economic recovery prospects. It is possible that the central bank will announce an extension of its Quantitative Easing programme on Thursday, but we believe it is more likely that the MPC will wait another month to see what effect the measures taken so far are having.

The MPC's 9-0 vote in favour of unchanged interest rates at their April meeting and the general tone of the minutes reinforced belief that the view that interest rates have very likely troughed at 0.50%. The minutes did not reveal any discussion on the case for another cut in interest rates, only reporting that the MPC agreed that "no further change in Bank Rate was warranted this month." This is not surprising given that the MPC has indicated in the past that they believe bringing interest rates below 0.5% would have only a very limited positive impact at best, and could even be harmful. This is primarily due to the negative impact that this would have on banks' spreads and profitability, and hence potentially their lending. There is also a suspicion that a further interest rate cut would not be greatly passed on.

Meanwhile, the minutes suggested that the MPC is maintaining an open mind on whether or not its quantitative easing programme is sufficient or whether it will need to be extended or even reduced. The MPC seemed relatively happy overall with the initial impact of the quantitative easing programme, but clearly believed that it was premature at their April meeting to make any lasting judgements. Indeed, the MPC voted unanimously in continuing with the quantitative easing programme as agreed at their March meeting.

Since the MPC's April meeting, it has been revealed that U.K. GDP contracted 1.9% quarter-on-quarter in the first quarter of 2009. This was clearly deeper than the MPC was anticipating, as they had indicated that they expected the rate of decline to be around the 1.6% quarter-on-quarter drop seen in the fourth quarter of 2008. Countering this though, there have been increasing signs in some of the latest data and survey evidence that the rate of decline in economic activity is starting to moderate.

In particular, the purchasing managers' survey for the manufacturing sector showed activity rising to an eight-month high in April, while the latest service sector survey put activity at a six-month high in March: both surveys still pointed to clear contraction. Meanwhile, consumer confidence rose to a 12-month high in April, the Confederation of British Industry (CBI) reported surprisingly robust retail sales in April, and mortgage activity has edged up from its record-low levels. Nevertheless, the economy is still clearly contracting markedly and actual recovery still looks some distance away.

Furthermore, although survey evidence indicates that banks are becoming more willing to lend, credit conditions currently remain very tight.

Meanwhile, annual consumer price inflation retreated to 2.9% in April from 3.2% in March, and a peak of 5.2% last September. While this is still above the Bank of England's 2.0% target level and inflation has proved to be somewhat stickier than expected in recent months, it still seems likely to fall markedly further over the coming months. This is expected to be the consequence of heightening pressure on retailers to price competitively in the face of muted consumer spending, companies' diminished pricing power through the supply chain, sharply lower oil and commodity prices compared to 2008's peak levels, and favourable base effects as last year's sharp rises in utility prices increasingly drop out of the calculation. These factors should outweigh the inflationary impact of sterling's marked depreciation.

Given this backdrop, we expect the MPC to keep interest rates at 0.50%, not only on Thursday but deep into 2010. We also suspect that the quantitative easing programme is likely to be extended. We believe that it is unlikely that the MPC will make any further major announcements on its quantitative easing programme on Thursday. The Bank of England is on course to complete its intention to purchase £75 billion in assets (gilts and high quality corporate debt) through the issuance of central bank reserves over three months from start of the programme in March. We believe the MPC will prefer to sit tight for another month to see more evidence on how this is working before deciding whether the programme needs to be extended and widened, or even curtailed.

MAIN ECONOMIC RELEASES

The construction purchasing managers index (PMI—out on Tuesday) is forecast to have shown further very limited improvement in April having climbed off February's record low in March. We expect the PMI to have climbed to 32.0 in April from 30.9 in March and an all-time low of 27.8 in February (the series started in 1997). This would still be one of the lowest levels on record and massively below the 50.0 level that indicates unchanged activity. New orders contracted at a marginally reduced rate in March, while the sector will be helped to a limited extent by the government bringing forward some public construction activity and infrastructure spending as part of its fiscal stimulus package. Even so, with the housing market and commercial property sectors currently still under serious downward pressure, it is hard seeing the travails of the construction sector easing substantially any time soon. The latest national accounts data show that construction output plunged by 2.4% quarter-on-quarter and 8.6% year-on-year in the first quarter of 2009, which was the fourth successive quarter-on-quarter drop.

The service sector purchasing managers' index (out on Wednesday) is forecast to show that the rate of decline in the dominant sector slowed further in April. We expect the business activity index to have climbed to 46.0 in April after rising to a six-month high of 45.5 in March from 43.2 in February and a record low of 40.1 in November 2008. Nevertheless, this would still indicate a twelfth month of contracting activity (below 50.0). The services sector remains under serious pressure from reduced consumer expenditure on services, reduced business spending, still serious financial sector problems and the deep housing market downturn.

Producer price data for April (out Friday) should provide further evidence of manufacturers' markedly reduced pricing power in the face of recent extended sharply contracting activity and orders. Specifically, we expect headline annual producer output prices to have risen 0.2% month-on-month in April, thereby causing the annual rate of increase to moderate to a four-year low of 0.7% from 2.1% in March and a record peak of 10.0% in July 2008. Core output prices are also forecast to have risen 0.2% month-on-month in April. This would bring the year-on-year increase down to 2.3% in April from 3.3% in March and a peak of 6.3% last July. Meanwhile, the consensus is for producer input prices to have risen 0.8% month-on-month in April as oil prices rose from their lows earlier in the year and the weak pound pushed up the prices of some imported raw materials and commodities. Nevertheless, producer input prices are seen falling 3.6% year-on-year in April, in marked contrast to the record rise of 34.1% seen in June 2008.

Meanwhile, the Halifax is forecast to report during the week that the decline in house prices moderated to 0.8% month-on-month in April from 1.9% month-on-month in March. Consequently, house prices are seen falling 17.5% year-on-year in the three months to April. The Nationwide has already reported that house prices fell by 0.4% month-on-month and 15.0% year-on-year in April.

While evidence is mounting that housing market activity has passed its low point, current still very poor economic fundamentals and still relatively tight credit conditions suggest that the improvement in activity will be gradual and fitful for some time to come and that any substantial upturn remains well into the future. Consequently, house prices still look poised to fall for some time to come, although the rate of decline may now gradually ease. Specifically, we expect house prices to fall by around another 15% from their current levels to bottom out around mid-2010. This would leave them some 35% below the peak levels seen around August/September 2007.

By Howard Archer