PERSPECTIVES. The economy grew well in 2016 Q2: the Bank should. wait for signs of slowdown before further monetary easing

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1 PERSPECTIVES By Ruth Lea, Economic Adviser to the Arbuthnot Banking Group The economy grew well in 216 Q2: the Bank should 1 Ruth Lea Economic Adviser Arbuthnot Banking Group ruthlea@arbuthnot.co.uk wait for signs of slowdown before further monetary easing 1st August 216 Introduction As we discussed recently, there will be a paucity of ONS data on economic developments post the Brexit vote (23rd June) until September or October. 1 And, as and when the figures are released, it will be impossible to identify with any confidence the impact of the vote itself, such are the other factors influencing the economy, not least of all the possible slowdown in the world economy. We can never know the counter-factual. However, the data that has been released in recent weeks suggest that the economy was doing well ahead of the vote and seemed to be un-phased by the uncertainties created by the (then) upcoming referendum. And this is despite the suggestions in, for example, the Markit surveys that such uncertainties were depressing activity. 2 UK GDP data for 216Q2 were surprisingly firm and the labour market continued to improve in the second quarter. Developments in the second quarter Of the ONS s latest releases, the most significant related to GDP for 216Q2. The preliminary estimate increased by a greater-than-expected.6% in 216Q2 compared with.4% in 216Q1 (chart 1), to be 2.2% higher than a year earlier. 3,4 Growth was driven by the services sector (79% of the economy), which rose by.5% (QOQ), and production including manufacturing (15% of output), which rose by 2.1%. Construction output (6% of output) slipped.4%. The preliminary estimate is based on output data and there is no breakdown by expenditure components though these will be available next month with the second estimate. The ONS calculated that the GDP level in 216Q2 was 7.7% higher than the prerecession peak (28Q1). From peak (28Q1) to trough (29Q2) the economy shrank 6.3%.

2 Separately, the ONS said the services sector grew by.1% (MOM) in May, after a.6% increase in April, to be 2.7% higher than a year earlier. 5 Over the year the largest contributions came from business services and finance. Chart 1 GDP data (QOQ, %), ONS outturns, OBR forecasts (November 215, March 216) Q4 216Q3 216Q2 216Q1 215Q4 215Q3 215Q2 215Q1 214Q4 214Q3 214Q2 214Q1 OBR, Nov 215 OBR, Mar 216 ONS, Jul 216 Sources: (i) OBR, Economic and fiscal outlook, March 216; (ii) ONS, GDP, preliminary estimate, 216Q2, 27th July 216. The ONS s latest labour market report was equally encouraging, though it should be noted that the latest data related to May. Employment rose by a buoyant 176, in the three months to May compared with the previous three months, to be 624, higher than a year earlier. 6.7 And the employment rate (the proportion of people aged from 16 to 64 who were in work) was 74.4%, the highest since comparable records began in Similarly, unemployment (at 1.65m in the three months to May) was 54, down on the previous quarter and 21, down YOY. The unemployment rate fell to 4.9%, compared with 5.6% a year earlier, a significant fall by any standards. The last time it was lower was for July- September 25. Vacancies remained buoyant, though there was some slippage in the latest figures. Even though the annual growth of average weekly earnings remains modest, (2.3% (including bonuses) and 2.2% (excluding bonuses) in the three months to May) it is comfortably outstripping prices of inflation, thus boosting real incomes. Other data releases were mixed, biased to the better. These included: Public sector net borrowing (PSNB-ex, excluding public sector banks) was a better-thanexpected 7.8bn in June 216, 2.2bn lower than in June 215, after two months of disappointing higher-than-expected borrowing. 8 However, the cumulative total for PSNB for the first three months of FY216 was 25.6bn, just 2.3bn down (8%) on the 27.9bn recorded for the first three months of FY215. The OBR s March forecast for the FY216 total was of 55.5bn (March Budget), compared with an outturn of 75.3bn (revised) for FY215, an implied improvement of over 26%. On current trends the March Budget forecast for FY216, therefore, is almost certain to be missed. 2

3 Even though retail sales slipped.9% (MOM) in June, this followed two very strong months of growth and the annual increase was 4.3%. 9 Growth in 216Q2 was a fairly strong 1.6%. June s figures could have been adversely affected by the poor weather. June s CPI annual inflation rate was.5%, boosted by higher air fares (possibly connected to the Euro 216 football tournament), compared with.3% in May. 1 Though higher than in previous months, June s CPI inflation rate was still relatively low historically and we expect it to remain well contained. 11 The core rate of inflation (excluding energy, food, alcoholic beverages and tobacco) was 1.4% in June, compared with 1.2% in May. Recently released ONS data on house prices suggest the market was still firm overall despite the imposition of the 3% stamp duty surcharge on second homes (1st April), though it should be noted that the latest available ONS figures relate to May. Average house prices rose by 1.1% (seasonally adjusted, MOM) in May to be 8.1% (YOY), unchanged from April. 12 However, Bank of England data on mortgage approvals for house purchase have tended to weaken in recent months, probably reflecting the stamp duty surcharge. 13 We discuss Nationwide s July house price findings below. Post-referendum developments Suffice to say the only information available on post-referendum developments relate to anecdotal evidence and surveys. They range from the apocalyptic to the cautiously encouraging. The former category included the latest GfK consumer confidence barometer (for July), which experienced the steepest decline for 26 years. 14 And IHS Markit s flash PMI composite output index fell to 47.7 in July, an 87-month-low, compared with 52.4 in June Any rating below 5 suggests contraction. On the other hand, the Bank of England s Agents Summary of Business Conditions, which covered intelligence gathered from business contacts between late May 216 and late June 216, was more encouraging, suggesting there was a pragmatic business as usual approach to the referendum result. 17 Given the significance of the Bank, it is worth noting the Agents findings in more detail: The annual rate of activity growth had remained moderate and little changed in the month up to the EU referendum. Consumer spending and construction output growth had eased a little, offset by a pick-up in manufacturing growth from a low base. There had been further signs of uncertainty leading to delays in decision-taking, including on capital spending, hiring and property investment. Following the EU referendum, business uncertainty had risen markedly. Many firms had only just begun to formulate new business strategies in response to the vote and, for the time being, were seeking to maintain business as usual. A majority of firms spoken with did not expect a near-term impact from the result on their investment or staff hiring plans. But around a third of contacts thought there would be some negative impact on those plans over the next 12 months. As yet, there was no clear evidence of a sharp general slowing in activity. 3

4 And the Nationwide reported that house prices actually rose by.5% in July compared with June, to be 5.2% up on a year earlier The impact of the Brexit vote on the housing market, they concluded, was uncertain. Interestingly, these findings are from an institution which has estimated that house prices increases have been lower than the ONS s in recent months and may, therefore, be regarded as cautious. By contrast, the Halifax s series has been higher than the ONS s over the past year, but it has shown some notable weakening since the imposition of the stamp duty surcharge. 2 Chart 2 House prices increases (YOY, %), from July Halifax 8 ONS 6 Nationwide 4 2 Jul-16 Jun-16 May-16 Apr-16 Mar-16 Feb-16 Jan-16 Dec-15 Nov-15 Oct-15 Sep-15 Aug-15 Jul-15 Jun-15 May-15 Apr-15 Mar-15 Feb-15 Jan-15 Dec-14 Nov-14 Oct-14 Sep-14 Aug-14 Jul-14 Sources: (i) ONS website; (ii) Nationwide, House price growth steady in July, 28th July 216; (iii) Halifax, Annual house price growth eases to 8.4% (for June), 7th July 216. The other encouraging development has been the continued resilience of the markets, as commented on recently by a very measured ECB President Mario Draghi Last week the FTSE1 was at a 12-month high and the FTSE25 had recovered its post-vote losses. 23 The pound ended last week at /$1.32, compared with around /$1.45 in the weeks leading up to the referendum. This represents a depreciation of around 9%, a fair competitiveness boost not a rout. Changes in monetary and fiscal policy? The next MPC meeting is on 4th August, when the Bank s August Inflation Report, with updated forecasts, will be released. There are expectations that GDP growth will be revised down, whilst inflation will be revised up (see annex table 1 for the May forecast). 4

5 Concerning the MPC, the markets are expecting further monetary easing (possibly a.25% cut in rates and/or more QE), as hinted by the Governor There are, however, at least two MPC members who have, very sensibly, said they prefer to wait for official data indicating slowdown before making any policy decisions: Martin Weale and Kristin Forbes Weale s recent speech on Brexit and monetary policy included the following, very relevant, rejection of two arguments for rate cuts: 28 Firstly, he rejected the notion that markets would be disappointed if there were no easing in August, noting that market participants should remember that the MPC sets policy each month - not in advance. Secondly, he gave little weight to the argument that early action was needed to reassure people, noting there was no sign consumers or businesses were panic-struck. Turning to fiscal policy, Chancellor Hammond had said he may use the Autumn Statement to reset Britain s economic policy, adding that the Treasury would act if we deem it necessary to do so. 29 There will, at the minimum, have to be some new fiscal rules, not least of all because the budget surplus target for 22 has been dropped. 3 In the meantime, it is highly unlikely there will be any fiscal changes. Weaker growth in the Eurozone Eurostat released some key data for the Eurozone last week, which suggested that the recovery may be weakening, but note quarterly data can be erratic and subject to residual seasonality. And the data for the individual member states are incomplete (there are no data yet for Germany and Italy, for example). Eurozone GDP rose by just.3% (QOQ) in 216Q2, much as expected, after a.6% increase in 216Q1 (chart 3). 31 The YOY growth was just 1.6%. Data are available for France, the Eurozone s second biggest economy, which stalled in the second quarter after posting.7% growth in the first. First quarter growth had been supported by people booking accommodation and buying tickets for the Euro 216 football championship At this juncture it is possible the ECB will offer further monetary stimulus to help the recovery, even though there was no change in policy at the meeting on 21st July. The ECB will be updating its growth and inflation forecasts for its next meeting on 8th September, when any policy action deemed necessary could be launched. 34 Incidentally, Eurozone annual inflation edged up to.2% in July 216, compared with.1% in June, though still below the ECB s target of around 2%. 35 The core rate (excluding energy, food, alcohol and tobacco) was unchanged at.9%. 5

6 Chart 3 Quarterly GDP growth (%), selected Eurozone countries & UK, 215Q3-216Q EU28 Eurozone Germany France Italy Spain Greece Netherlands Ireland Portugal UK Q3 215Q4 216Q1 216Q2 Sources: (i) Eurostat, GDP up by.6% in euro area & by.5% in the EU28, 7th June 216; (ii) Eurostat, GDP up by.3% in the euro area & by.4% in the EU28, 29th July 216; (iii) Ireland s data from Central Statistics Office; (iv) UK data from ONS. Indications that the recovery may be weakening is clearly disappointing, not least of all because unemployment is still shockingly high in many Eurozone countries. The aggregate unemployment rate was 1.1% in July, unchanged from June, though down on July 215 s 11.% (chart 4a). 36 But the range is very wide: Germany s unemployment rate was 4.2%, whilst Greece s was 23.3%, Spain s was 19.9% (despite the recovery) and Italy s was 11.7%. Moreover, Italy s general economic problems of sluggish growth and high unemployment are exacerbated by a troubled banking sector, bedevilled by bad loans. In the European Banking Authority s (EBA s) latest stress tests on banks, Italy s Monte dei Paschi di Siena was by far the worst performer, with the test forecasting that 14% of its capital would be wiped out under adverse conditions The youth unemployment rates are far worse than the aggregate rates (chart 4b). Nearly a half of Greek and Spanish young people (under 25s) are unemployed and over a third of Italian. 6

7 Chart 4a Unemployment rates (%), selected Eurozone countries & UK, June 215 and June Eurozone Germany France Italy Spain Netherlands Greece Ireland Portugal UK Jun-15 Jun-16 Chart 4b Youth unemployment rates (%), selected Eurozone countries & UK, June 215 and June Eurozone Germany France Italy Spain Netherlands Greece Ireland Portugal UK Jun-15 Jun-16 Source: Eurostat, Euro area unemployment down to 1.1%, June 216, 29th July 216. Data relate to April for UK and Greece. 7

8 The US: disappointing GDP data After the very strong labour report for June, when the increase in non-farm payrolls was a buoyant 287,, the advance estimate for GDP for 216Q2 was very disappointing GDP rose by 1.2% (annualised), considerably less than the 2.5% expected, after weak growth of just.8% in 216Q1. The average was, therefore, only 1.% for 216H1, adding to the general worries that the global economic recovery may be losing impetus irrespective of the Brexit effect. The weakness was led by investment, both corporate and residential, whilst weaker inventories and public spending also dragged down GDP growth. Consumption growth, however, accelerated from 1.6% to 4.2% in 216Q2, whilst the trade balance made a positive contribution (exports rose as imports fell). The poor GDP figure may dim speculation that the Federal Reserve will, after all, raise rates later this year. Ironically, the rate-setting Federal Open Market Committee (FOMC) seemed more hawkish at its 27th July meeting than it had done in June, opening the door to a rate rise. 42 The FOMC has three scheduled meetings left in 216 (September, November and December) when it can raise rates. But with weak GDP growth and the complicating factor of the US presidential election outcome in November, and the implications for business confidence, it may choose to hold rates instead. The IMF s latest forecasts In its July update the IMF shaved global growth for 216 to 3.1% (compared with April s 3.2%) and for 217 to 3.4% (from 3.5%) (see chart 5a and annex table 2). 43 According to Maury Obstfeld (IMF Economic Counsellor and Director of the Research Department) the first half of 216 revealed some promising signs, for example, stronger than expected growth in the euro area and Japan, as well as a partial recovery in commodity prices that helped several emerging and developing economies As of June 22nd, we were therefore prepared to upgrade our global growth projections slightly. But Brexit has thrown a spanner in the works. 44 The degree to which the IMF seems prepared to attribute ( blame ) the current woes of the global economy to the Brexit vote can be seen from the following: 45 Before the June 23rd vote in the United Kingdom in favour of leaving the European Union, economic data and financial market developments suggested that the global economy was evolving broadly as forecast in the April 216 WEO. The outcome of the UK vote, which surprised global financial markets, implies the materialisation of an important downside risk for the world economy. As a result, the global outlook for has worsened, despite the better-than-expected performance in early 216. This deterioration reflects the expected macroeconomic consequences of a sizable increase in uncertainty, including on the political front. This uncertainty is projected to take a toll on confidence and investment, including through its repercussions on financial conditions and market sentiment more generally. The initial financial market reaction was severe but generally orderly. As of mid-july, the pound has weakened by about 1%, despite some rebound; equity 8

9 prices are lower in some sectors, especially for European banks; and yields on safe assets have declined. With Brexit still very much unfolding, the extent of uncertainty complicates the already difficult task of macroeconomic forecasting. The baseline global growth forecast has been revised down modestly relative to the April 216 WEO (by.1% for 216 and 217, as compared to a.1% upward revision for 217 envisaged pre- Brexit). Brexit-related revisions are concentrated in advanced European economies, with a relatively muted impact elsewhere, including in the US and China. Pending further clarity on the exit process, this baseline reflects the benign assumption of a gradual reduction in uncertainty going forward, with arrangements between the European Union and the United Kingdom avoiding a large increase in economic barriers, no major financial market disruption, and limited political fallout from the referendum. But more negative outcomes are a distinct possibility. This assessment seems overly harsh on the UK, to put it mildly, albeit consistent with the pre-referendum warnings from the IMF if a Brexit vote. The slowing of the US economy and the ongoing modest Eurozone performance are surely more significant. The IMF s main changes were: Prospects for the US economy were, presciently, downgraded with projected growth in 216 cut to 2.2% from 2.4%. The UK forecast was, arguably, the most changed with growth for 216 cut to 1.7% (from 1.9%) and growth for 217 cut to 1.3% (from 2.2%), reflecting the Brexit vote. The UK is, however, still expected to grow quicker in 216 than either Germany or France (chart 5b and annex table 2). The Eurozone growth forecast for 216 was modestly upgraded, whilst French growth was upgraded from 1.1% to 1.5%. Given France s poor GDP outcome for 216Q2 this new projection may be difficult to achieve. World trade growth has been downgraded and the fall in oil prices for 216 is now expected to be much less severe. 9

10 Chart 5a IMF GDP forecasts, growth rates (%): Oct 215, Jan 216 & Apr 216 forecasts World GDP USA Eurozone UK 216 (Jan 216) 216 (Apr 216) 216 (Jul 216) 217 (Jan 216) 217 (Apr 216) 217 (Jul 216) 1 Chart 5b IMF GDP forecasts, growth rates (%): G7 and BRICs economies World US Germany France Italy Japan UK Canada Brazil Russia India China Sources: (i) IMF, Uncertainty in the aftermath of the UK referendum, July update, 19th July 216; (ii) IMF, World Economic Outlook: too slow for too long, April 216. See also annex table 2. 1

11 References 1. Ruth Lea, The Authorities begin to get to grips with Brexit: post-referendum update, Arbuthnot Banking Group, 18th July The Markit surveys for June were discussed in Ruth Lea, The Authorities begin to get to grips with Brexit: post-referendum update, Arbuthnot Banking Group, 18th July 216. It is, however, possible that monthly growth in June slipped after a strong April and May. 3. ONS, GDP, preliminary estimate, 216Q2, 27th July BBC, UK economic growth sped up ahead of Brexit vote, 27th June ONS, Index of services, May 216, 27th July ONS, Labour market, July 216, 2th July BBC, UK unemployment rate falls to fresh 11-year low, 2th July ONS, Public sector finances, June 216, 21st July ONS, Retail sales in GB, June 216, 21st July ONS, UK consumer price inflation, June 216, 19th July ONS, UK producer price inflation, June 216, 19th July 216, reported that output prices fell.4% in the year to June 216, compared with -.6% (YOY) in May. Core factory gate prices (excluding food, beverages, tobacco & petroleum) rose just.7% (YOY), slightly more than in May (.6%). Factory gate inflation is, therefore, well under control. Input prices, materials and fuel bought by UK manufacturers for processing, fell by.5% (YOY) (-4.4% in May). Crude oil prices rose 7.5% (MOM) in June to be 11.1% down (YOY). 12. ONS, UK house price index: May 216, 19th July 216. The UK s four countries showed very different inflation rates in May: England (8.9%), Wales (3.6%), Scotland (4.%) and Northern Ireland (5.9%). In England there was, as always, a significant range across the regions: London (13.6%), South East (12.9%), East England (12.8%), East Midlands (7.9%), South West (7.4%), West Midlands (6.7%) North West (4.3%), Yorkshire & Humberside (3.8%), and the North East (3.2%). The pace of price increases in London is especially noticeable, after a period of relative softness. 13. Bank of England, Money and credit, June 216, 29th July 216. Mortgage approvals for house purchase slipped in June to 64,766, compared with May s 66,722, and were lower than the average for the previous six months (69,998). 14. Times, Confidence lowest for 26 years as consumers feel Brexit blues, 29th July Daily Telegraph, Early warning of dramatic deterioration in economy, 23rd July IHS Markit, UK economy contracts at steepest pace since early-29, Markit flash UK PMI, 22nd July 216. The results were: (i) flash UK PMI composite output index 47.7 (July), 52.4 (June), 87-month low; (ii) flash UK services PMI activity index 47.4 (July), 52.3 (June), 88-month low; (iii) flash UK manufacturing PMI 49.1 (July), 52.1 (June), 41-month low; (iv) flash UK manufacturing PMI output index 49.1 (July), 52.9 (June). 17. Bank of England, Agents Summary of Business Conditions, July 216 update, 2th July Nationwide, House price growth steady in July, 28th July BBC, Brexit impact on house prices is uncertain, Nationwide says, 28th July Halifax, Annual house price growth eases to 8.4% (for June), 7th July 216. July data are available on 5th August. Only 13 Months of data are now available from the Halifax press releases. 21. Times, Brexit fears have been overblown, Draghi says, 22nd July

12 22. Daily Mail, Eurozone bank boss keeps calm on Brexit, 22nd July 216, reported that Draghi had said that the markets had shown resilience since the result. 23. CityAM, No sign of Brexit blues as FTSE1 hits 12-month high and FTSE25 back in the black, 28th June Ruth Lea, The Authorities begin to get to grips with Brexit: post-referendum update, Arbuthnot Banking Group, 18th July 216, discussed the Governor s recent warnings. 25. Ruth Lea, The Bank reduces growth forecasts, as the Governor warns on Brexit, Arbuthnot Banking Group, 23rd May 216, discussed the Governor s pre-vote warnings. 26. Times, Brexit fears have been overblown, Draghi says, 22th July Times, Bank must play waiting game before cutting rates, says Weale, 19th July Bank of England, Brexit and Monetary Policy a speech by Martin Weale, 18th July BBC, Chancellor may reset economic policy in Autumn Statement, 22nd July Osborne s fiscal rules were (i) in normal times, once a headline surplus had been achieved, the target was for a surplus on PSNB in each subsequent year. Note that for the period from FY215 outside normal times, the target was still for a surplus on PSNB by the end of FY219; (ii) for this mandated period until FY219, there was a supplementary target for PSND, which should be falling as a % of GDP in each year. 31. Eurostat, GDP up by.3% in the euro area & by.4% in the EU28, 29th July BBC, Eurozone GDP growth halves as French economy stalls, 29th July FT, French woes slow growth in Eurozone, 3th July Times, Brexit fears have been overblown, Draghi says, 22nd July Eurostat, Euro area annual inflation up to.2%, flash estimate for July 216, 29th July Eurostat, Euro area unemployment down to 1.1%, June 216, 29th July EBA, EBA publishes 216 EU-wide stress test results, 29th July BBC, RBS performs poorly in stress tests, 29th July BBC, US job creation rebounds strongly in June, 8th July Bureau of Economic Analysis, National Income and Product Accounts, GDP 216Q2 (advance estimate), 29th July FT, US expansion slackens amid fears over global weakness, 3th July FT, Fed door open to second rate rise, 28th July IMF, Uncertainty in the aftermath of the UK referendum, July update, 19th July BBC, Brexit throws spanner in the works of global growth, 19th July IMF, Uncertainty in the aftermath of the UK referendum, July update, 19th July