NEWS / Foreign Exchange

United Kingdom 16/10 Consumer Prices (Sep)

United Kingdom

16/10 Consumer Prices (Sep)

The September consumer prices figures were again better than expected ??“ that makes three months in a row that inflation has surprised market expectations on the downside. Instead of ticking up to 1.9%, which was the consensus forecast, annual CPI inflation was unchanged at 1.8%. Within this there were sharp increases in food prices, mainly reflecting the much publicised increases in milk and dairy prices. But these were offset by falls in seasonable vegetable prices, the continued phasing in of lower gas and electricity tariffs and smaller increases in clothing and footwear prices compared with a year ago. Interestingly, petrol also had a large upward effect on the annual rate (due mainly to the unwinding of helpful base effects last year), but this was cancelled out by larger than usual seasonal reductions in air and sea fares. Excluding energy, food, alcohol and tobacco, the core annual rate fell from 1.8% to 1.5%, the lowest in exactly a year. Meanwhile, the annual rate of change in the RPI eased from 4.1% to 3.9% (again lower than expected) primarilyas a result of last September??™s mortgage rate increase dropping out of the annual comparison.

The figures should have removed any remaining doubt that interest rates have peaked. Although the MPC??™s central inflation projection made at the time of the August Inflation Report had assumed a near-term dip below 2%, the fall has in fact been significantly larger than expected. Thus, inflation in the third quarter has averaged 1.8% compared with 2.6% in Q2 and a peak in March of 3.1%. Everything else being equal, this must mean that inflation will be lower than 2% in two years??™ time, even with interest rates kept at current levels or possibly even slightly lower. With the Treasury having lowered its growth forecast for the 2008, we can expect a similar downward adjustment in the next Inflation Report in November. Whether this will provide sufficient scope for the MPC to justify a rate cut in November is open to debate. We still think the Committee will want to see confirmation that sub-trend growth has resumed, which may not now (given the resilience of retail sales in recent months as retailers have stepped up their price discounting) be until Q4, the data for which won??™t be published until the end of January. February therefore still looks the most likely time for the first rate cut.

17/10 Minutes of October MPC Meeting

In so far as one member of the Committee voted for an immediate 25 basis point cut in interest rates, the minutes of the October MPC meeting were more ???dovish??? than financial markets had been expecting. However, more important than this was the recognition by the eight members who voted to maintain rates at 5.75% that the upside risks to inflation had been reduced and that inflation during the third quarter had been lower than was assumed at the time of the August Inflation Report. That said, whilst the case for an immediate rate cut was discussed, the majority concluded that with the economy still buoyant ???there was time to consider how developments in credit conditions would affect the outlook for inflation???. Consequently, the committee decided that the preparation of the November Inflation Report would provide a better opportunity to ???reach a more considered judgement and to explain its policy stance???. The MPC is therefore in wait-and-see mode. We still think the first rate cut is more likely to happen in February, but the tone of these latest minutes has increased the prospect of a cut in early November.

17/10 Labour Market (Sep/Aug)

Financial markets generally viewed the September labour market report as robust. Unemployment fell again (on both measures), employment continued to rise and average annual earnings growth ticked up. However, beneath the surface there was plenty in the report to suggest softness. First the rate of job creation slowed sharply, with employment rising 22,000 in the three months to August compared with 95,000 in the previous three months. What??™s more the type of job created was symptomatic of slowing economic conditions. The number of full time employee jobs rose 22,000 during the period, but the number of men working in such positions fell 25,000. At the same time, self employment jumped 22,000, whilst more than 80% of all new jobs were filled by workers who were above the state retirement age. All of these factors are acting to constrain the growth in household disposable incomes. They also help explain why wage inflation has been so remarkably subdued during this cycle. Indeed, even after the latest rise, at 3.7% annual average earnings growth remains substantially beneath the ???safe maximum??? that the Bank of England considers compatible with target inflation. Consumer demand held up in Q3, but it is likely to slow abruptly over the coming few quarters.

18/10 Retail Sales (Sep)

Once again, the latest retail sales volume figures ??“ up 0.6% in September following a 0.7% advance in August ??“ were stronger than financial markets. And once again, the figures were met with the now familiar refrain that UK consumer demand is simply too strong to be compatible with target inflation. But the present strength of UK retailsales volumes reflects one thing and one thing only; the fact that retailers are continuing to slash prices, thereby effectively boosting real purchasing power, in an attempt to draw in customers. True, prices overall only edged down 0.1% in September, but in the key non-food sector, which is more responsive to variations in price (relatively demand elastic to use the jargon), prices fell 0.7% last month. This brought the cumulative decline over the third quarter to 1.7% and that over the past year to 3.3%. This represents a massive boost to real household income. Much of the action has been in household goods stores, where volumes have surged 9.6% over the past year but prices have fallen 7.1%. As a result, the cash value of such sales has risen a comparatively modest 2.6%. Similarly, non-store retailing (which includes on-line and mail order sales) has seen volumes soar 12.7% in response to an 8.8% drop in prices, although this has left sales values up 3.9%. The point of all this is to emphasise that the ???surprising resilience??? of retail sales volumes is not symptomatic of a run-away consumer boom similar to that observed in the late 1980s. If it were, we would expect to see surging volumes and prices. Nevertheless, the upshot of these latest figures has been an increase of 1.7% in retail sales volumes in Q3. This in turn has supported overall consumer spending and therefore GDP. But given the mounting pressures from debt servicing costs, sluggish nominal wage growth and the fall out from the credit crisis, this situation simply cannot persist indefinitely. Retail and overall consumer spending will slow markedly in Q4.

Economic growth again surprised on the upside in Q3, with overall economic activity expanding by 0.8%, the same as in each of the previous three quarters. This extends the period of continuous above trend growth to seven quarters, which more than any other single factor explains why the MPC is in no rush to lower interest rates. The sector breakdown of the data reveals that after recovering in Q2, industrial activity has slowed again. Consequently, growth was maintained at 0.8% only because activity in the services sector picked up, rising by 1.0% compared with 0.9% in Q2. Within this, the acceleration in distribution, hotels and catering mirrors the strength of retail sales volumes in recent months. However, the main engine of growth over the quarter was business services and finance, which expanded by 1.7%, the same as in Q2. Indeed, in each of the last two quarters, business services and finance has accounted for more than half of the increase in economic activity during the period. But given the recent turmoil in financial markets, and the updates from a number of majorfinancial institutions, this is unlikely to be repeated over the coming few quarters. By definition, this means the pace of economic expansion will slow abruptly over the coming few quarters; even if business services and finance expands by 0.5% in Q4, this will reduce the increase in headline GDP by 0.3-percentage points everything else being equal. Thus, whilst economic growth now looks like coming in at 3.0% this year, we expect it to slow to just 1.7% in 2008.

United States

17/10 Consumer Prices (Sep)

Overall consumer prices rose a slightly larger than expected 0.3% in September, reflecting a 0.4% rise in energy prices and a 0.5% increase in food prices. Consequently, the core index, which excludes both food and energy, rose 0.2%, in line with market expectations. This was the fourth successive 0.2% monthly increase, and left the annual rate unchanged at 2.1%. Some commentators see this as too high and likely to preclude further interest rate cuts. After all in pursuit of its objective of price stability the Federal Reserve is implicitly targeting core inflation of 1-2%. However, as we have pointed out before, because of the distortions associated with the treatment of the costs of owner occupation within the CPI, the Fed??™s target measure of inflation is in fact the personal consumption expenditure (PCE) deflator excluding food and energy. On this basis,core inflation was at a near four-year low of just 1.8% in August, down from 1.9% in September. What??™s more, the three-month on three-month annualised rate was even lower at 1.5%, suggesting the annual rate will ease further in the near-term. But what the inflation pessimists fail to comprehend is that after five successive quarters of subtrend growth in terms of final domestic sales the amount of spare capacity within the US economy is now significantly larger than it was at the beginning of 2006. Unless the US economy??™s long run sustainable growth rate has suddenly slumped from the widely accepted average of around 3.4%, it follows that inflationary pressures will continue to ease through the remainder of 2007 and all of 2008 as well. Although the Fed has cut interest rates early than most commentators had been expecting, we firmly believe it is taking no risks whatsoever with inflation.

17/10 Housing starts (Sep)

Although financial markets were braced for further slippage in September, not even the ultra-pessimists in the forecasting community could have envisaged that the number of privately owned housing starts would fall by 10.5%. This brought the monthly total down to 1.191 million at annual rates, the lowest since September 1992 and a massive 30.8% down on the level in September last year. As a result, the three month on three month rate of change, which had just returned to positive territory as recently as June, slumped to -11.5%. This is larger even than the declines seen in the first quarter of this year and the second, third and fourth of last year when residential fixed investment spending was falling at double-digit annualised rates. The clear implication is that residential investment will continue to act as major constraint on economic activity over the coming few quarters. It also means that the risks to our growth forecast of 2.3% in 2008 are stacked firmly to the downside. However, we continue to believe that recession will be avoided. For this to happen, the weakness we anticipate in residential fixed investment would need to spread to the consumer. But whilst consumer demand is likely to slow from here, the buoyancy of labour market conditions and the still comparatively high consumer confidence readings are simply incompatible with sustained outright declines in consumer spending.

United Kingdom

25/10 Nationwide House Prices (Oct)

Not for the first time in recent months, the Nationwide Building Society??™s measure of house prices was slightly stronger than expected in September. Against a central market expectation of 0.4%, seasonally adjusted house price advanced 0.7% last month, which is bang in line with the average seen over the last six months. Nevertheless,the indications are that house price inflation is slowing. Not only did the annual rate of change continue to decline, easing from 9.6% in August to 9.0%, but the key threemonth on three-month rate of change that we believe provides the best guide to the underlying trend continued to moderate, dropping from 2.2% in June to 1.6%, the slowest since July 2006. We believe we will see a further shift down over the coming few months. Latest figures show that the combination of the MPC increases in interest rates over the past year and the recent turmoil in credit markets is impacting materially on the demand for mortgage credit. True, the outstanding stock of mortgages is currently growing extremely rapidly, with figures for August showing only a modest deceleration in the annual rate of change to 10.8%. However, both the number and value of new mortgage approvals, which lead actual mortgage borrowing, are weakening markedly. Indeed, the number of new mortgage approvals fell 5.8% in August and are now 9.2% lower than they were in August 2006. At the same time, the value of mortgage approvals was down 4.8% on the month, which brings the total decline on a three-month on three-month annualised basis to 30.2%. And with mortgage interest payments now accounting for 10.1% of household disposable income compared with just 4.8% at the beginning of 2002 the squeeze on the personal sector is tightening. Although we still don??™t believe the housing market is about to crash, the annual rate of increase is heading for low, single figures, where it will remain for an extended period. Financial markets expect a rise of 0.3% in October, which would cut the annual rate to 8.6%.

United States

25/10 New Home Sales (Sep)

New home sales tumbled 8.3% in August, more than reversing July??™s upwardly revised 3.8% bounce. As a result, sales are now once again more than 20% down on year ago levels, whilst the three-month on three-month rate of change returned to negative territory. The question now is how much further can they fall? If we view the strength of new home sales since the turn of the century as the exception instead of the norm, then the answer could be ???not that much???. This is because the latest reading is back inside the range of monthly house sales seen during the three decades at the end of the 20th century. This is not to say that we won??™t see further declines in the near term, but we suspect that most of the correction has already happened. The consensus expectation for September is a fall of 2.5%.

25/10 Durable Goods Orders (Sep)

US durable goods orders were weaker than expected in August. Although a decline had been expected, the fall of 4.9% was more than twice the central market expectation. However, the core measure (non-defence, excluding aircraft in the capital goods industries) proved more resilient, edging down just 0.7% following a 0.9% rise in July. The bad news was that the three-month on threemonth annualised rate of change slipped back into negative territory, the first time it has done so since April.This has potentially ominous implications for non-residential fixed investment spending, which rebounded strongly in Q2. Indeed, the suggestion is that we could now see little if any growth in this component of aggregate demand in the third quarter. A rebound of 1.5% in the headline figures is the central expectation for September.

Eurozone

25/10 German IFO Business Climate Index (Oct)

The IFO business climate index for Germany (covering industry, retailing, wholesaling and construction) fell more than expected in September, dropping from 105.8 in August to 104.2. This was the fourth successive monthly decline and means that after coming within 0.1 of December??™s all time high of 108.7 the index has since fallen to its lowest level since February 2006. Nevertheless, even after such falls the index remains high in terms of its long run average. Admittedly, the fact that the expectations component sank to 98.7, the lowest since November 2005, points to further softness over the coming months. However, the key point remains that current levels remain wholly consistent with the German economy growing at an above trend rate through the remainder of 2007. A further decline to 103.8 is expected for October.

26/10 German Consumer Prices (Oct, prelim)

Consumer price inflation in Germany jumped from 2.0% in August to 2.4% in September. However, this acceleration primarily was due entirely to major energy price ???base??? effects rather than a pick up in underlying inflationary pressure. Essentially, falling energy prices pushed down the overall price level 12 months ago, which would need to be repeated over the coming six months for the annual rate of change not to rise. As a result, the underlying rate, which excludes energy, was unchanged at 2.0%.Financial markets are looking for the initial stab at the October headline figure to hold steady at 2.4%.