Royal Bank of Scotland

Posted on 23 Oct 2009 by The Manufacturer

Chief Economist's Weekly Briefing

Inflation was the main economic news last week across the UK, US and euro area. The UK remains the only one of the three not to have seen prices fall this year. But the steep fall in inflation last month (from 1.6% to 1.1%), and continued signs of economic weakness, suggests the MPC will remain on their guard against possible deflation.

The unemployment rate in the UK was steady at 7.9% in August. While this is a positive development for the UK labour market, the danger is that it will prove a temporary reprieve. Figures for September showing the number of people out of working and claiming benefits rose by almost 21K. This was the slowest monthly rise since May last year, but it probably reflects growing disillusionment about finding work – 258K workers lost their jobs last month as the number of vacancies declined and many people dropped out of the labour force.

September saw the lowest level of inflation in the UK for five years. While consumer prices continue to fall year on year in the US and euro zone, in the UK inflation remained positive at 1.1% on the consumer price index measure (CPI). Lower oil prices have helped bring down the cost of energy and fuel bills compared to last year and discounting from retailers helped clothing and footwear prices to tick down almost 7% on last September.

The retail price index (RPI), a broader measure of prices, remained in deflation territory, pulled down by lower mortgage interest payments. Data from the Council for Mortgage Lenders shows the average borrower spent 13% of pre-tax income on mortgage interest payments in August 2009, down from 18% a year ago. Historically low interest rates have significantly boosted mortgage affordability, reducing interest payments for the average new borrower by £182 a month.

Conditions in the housing market continue to improve, according to the Royal Institution of Chartered Surveyors. In September, a majority of surveyors again reported that prices were rising. The sales-to-stock ratio, a measure of market slack and a lead indicator of future prices, rose. New instructions to sell and new buyer enquiries were both up. There were also signs that the commercial property market was emerging from the mire as prices rose 1.1% on the month to September. But having fallen 44% in the last two years, values sit at their 1997 level.

In the US, the Dow Jones breached the 10,000 mark for the first time since October 2008, as positive Q3 US company earnings announcements and better-than-expected retail sales boosted investor sentiment. The Dow is up around 50% from its March lows.

US retail sales fell again in September, but by less than expected. The end of the ‘cash for clunkers’ program in August and higher gasoline prices led consumers to spend 1.5% less than the month before. Excluding autos and gasoline, sales rose by more than expected (0.4% m/m), on the back of a small rise in August. This suggests that consumer spending will have made a positive contribution to growth in Q3 and that the US economy will record a positive gain of 3% to 3.5% on a quarter-on-quarter annualised basis, the first increase following four consecutive quarters of contraction.

The minutes from the last meeting of the Federal Open Markets Committee, the US equivalent of the MPC, indicated the Federal Reserve remained concerned about deflation. The committee noted that, “most participants anticipated that slack in both labour and product markets would be substantial over the next few years, leading to subdued and potentially declining wage and price inflation.” As if on cue, September consumer price inflation came in at minus 1.3% y/y, a slight improvement on August (i.e. less negative), but indicative of continued deflation. Despite the recent improvement in activity, the Fed will be in no rush to raise interest rates.

In the euro area, the ZEW survey of investor sentiment in the region fell back modestly as expectations of growth levelled off. Opinions about current conditions improved, but by less than most analysts had expected. In Germany, investors had a profoundly negative take on the retail/consumer goods and automotive sectors.

Deflation is likely to be weighing on sentiment. Euro area consumer prices fell for the fourth consecutive month in September (0.3% y/y). Ireland saw the sharpest decline (-3%).

The recovery in euro area industrial production looks to be gaining momentum. Output rose in August (by 0.9% m/m), for the fourth month on the trot. Sectors that saw the biggest declines at the start of the recession are staging the strongest bounce back e.g. durable goods were up 5% m/m (although they still stand 20% below last year’s level).