Inflation data positive from interest rate viewpoint
The minutes of the January Monetary Policy Committee (MPC) meeting show just how close last month’s Base Rate decision was, with a five to four vote in favour of the 0.25 per cent increase. As expected, the MPC left Base Rate unchanged at the 8 February meeting. The most recent inflation data indicates that Base and period rates may well have peaked.
The January fall in inflation was greater than expected, producing a reduction in Consumer Price Index (CPI) from 3 per cent to 2.70 per cent. This was not a statistical aberration. There were falls in other measures of inflation, notably the Retail Price Index (RPI), which fell by 0.2 per cent to 4.20 per cent. This number is significant as it is used as a benchmark for pay negotiations.
The reduction in inflation largely reflects the impact of lower fuel prices on the transport and air travel components of the CPI. There were also substantial reductions in clothing and furniture prices, reflecting large scale discounting in the January sales. The MPC still has concerns over the level of recent pay settlements, although our perception is that there is a strict limit to the ability of corporate UK to agree to high pay claims. While money markets currently discount a further Base Rate increase, the Bank of England’s recent touch on the monetary brakes should be sufficient to achieve the MPC’s objective. Recently, utility companies have announced a significant reduction in domestic oil and gas prices, effective from next month. At present, we predict that Base Rate will remain unchanged until year-end, while the underlying trend in period rates in 2007 is likely to be a very gradual decline.
Strong economic growth
A larger than anticipated upturn in December inflation was probably the key factor behind the decision of the MPC to tighten monetary policy in January. The decision to increase Base Rate also reflected evidence of an upturn in activity in most sectors of the economy. The UK growth rate in Q4 2006 rose to 3 per cent per annum.
The key driver of the economy remains the service sector, which expanded at an annualised rate of 4 per cent in Q4 2006. The most rapidly expanding areas of the service sector are wholesale and retail distribution; transport and storage and business services and finance. The construction sector is also buoyant. The gradual upward trend in manufacturing remained in the run up to year-end, with annual growth in manufacturing production in December of 2.3 per cent.
A key challenge facing the MPC is what impact recent monetary tightening will have on the level of economic activity. Our perception is that UK growth will ease back in the second half of 2007 to the long-term trend rate of 2.50 per cent per year. This is compatible with service sector growth in excess of 3 per cent per year – this sector is the key driver of the housing market. This scenario is compatible with a strong housing market in 2007, but one whose strength is similar to first half 2006 rather than the high lending levels of final quarter 2006.
Mortgage market remains resilient
The first signs of a slowdown in the housing market are evident. The number of mortgage approvals fell by 15,000 in December to 113,000 a figure that is similar to the fourth quarter 2005 level. The most recent Royal Institute of Chartered Surveyors (RICS) survey shows that the number of new buyer enquiries is on a downward trend. The slowdown, in our view, represents a move from a housing market that was displaying signs of overheating to one whose growth rate is sustainable. The recent rise in Base and period rates may well slow the mortgage application rate from just over £30 billion per month (seasonally adjusted), to a monthly figure in the region of £28 billion. Given that the period rate market currently discounts one further Base Rate increase to 5.50 per cent, we believe that period rates from Q2 onwards will be on a marginally declining trend. The impact of the January rate move has led to a moderate reduction in our 2007 forecast of mortgage lending to £100 billion net and £330 billion gross.
House price inflation still well above sustainable levels
January house price data was decidedly mixed. The Nationwide Index rose by just 0.30 per cent in January, reducing the annual rate of house price inflation from 10.50 per cent to 9.30per cent. The Halifax Index rose by 1.30 per cent last month leaving the annual rate of house price inflation at 9.90 per cent per year. Data volatility is not unusual at the end of a house price cycle. We do not expect to see a sharp slowdown in the average level of house prices. The Bank’s current policy represents a firm touch of the monetary brakes designed to gradually bring down the average level of house price inflation to longer- term trend. Based on a view that base rate has peaked at 5.25 per cent, our house price forecast for 2007 is 6 per cent per year. We continue to predict that housing demand will exceed supply until the end of the decade. We anticipate that the total number of dwellings completed in 2007 will increase to 250,000. Building will need to remain at this level until at least 2010 before the overall level of housing supply and demand is in balance.
