Recent data, despite some eye-catching headlines, do not have straightforward implications for monetary policy. Those counting on a quarter-point rate cut during the fourth quarter may be disappointed.
The recent national accounts release left quarterly GDP growth unrevised at 0.5% between April and June, but year-on-year growth was only 1.5% (versus 1.8% annual growth in earlier estimates). This compares to trend UK GDP growth of close to 2.5% a year and marks the lowest year-on-year growth rate since 1993.
Overall, the pattern of subdued consumer spending growth is not being offset by stronger growth elsewhere. The September Confederation of British Industry distributive trades release meanwhile – showing the balance of retailers saying sales volumes are up versus a year ago against those saying sales are down – fell to the lowest level in its 22-year history (-24).
At first glance such data appears supportive of view that the Bank of England will cut interest rates again in the fourth quarter. Although we agree that there is a significant chance of a further rate cut, it is not our central case. We argue that upcoming rate decisions will be finely balanced and that the implications of recent data are not as clear cut as might first appear.
There still is little, if any, spare capacity in the economy
We used the revised GDP data to see if there is evidence that spare capacity has increased appreciably in recent quarters. But it hasn’t, according to the statistical models that we use. These suggest that there is at most slack amounting to 0.5% of potential GDP as of the second quarter. But some of our measures suggest output remains slightly above its potential level. All this suggests that the degree of slack in the economy remains low. Our assessment of current inflationary pressure arising from the pressure of demand on supply is unchanged.
Discretionary income growth accelerates
Our measure of ‘household discretionary income’ grew in the second quarter. The acceleration in annual growth to 3.0% can be largely attributed to continued robust growth in incomes but also to slower year-on-year increases in mortgage payments. Although limited history means that we cannot back-test this data, this series suggests that the consumer saw their (nominal) spending power increase significantly in the first half. Although the desire to save and recent rise in petrol prices suggest that consumers are unlikely to increase their pace of spending in the near term in response to robust income growth, it does suggest that prolonged falls in consumer spending look unlikely.
Debt servicing looks less onerous
Debt servicing (mortgage interest payments plus interest payments) as a percentage of household income declined in the second quarter. Relatively stable house prices and mortgage rates have likely helped, combined with continued income growth (real disposable income grew by a quarterly 1.1%). Again, such data suggest that fears of a consumer spending recession may be overdone.
The Monetary Policy Committee may want more data. The CBI survey result, at face value, implies a spending ‘collapse’. The indicator is at a 22-year low. However, the long run mean of that series appears to be unstable – comparisons with earlier years may be misleading. Further, August and September last year were strong months of retail sales growth and year-on-year comparisons should improve in October. For example, flat retail sales on the official measure in September and October would leave year-on-year retail sales growth at -0.2% (the lowest since July 1992) and 0.5% respectively.
The CBI distributive trades survey is very volatile month-to-month and MPC members may want more consumer related information before making a decision to cut rates. Income growth and continued low unemployment suggest the underlying fundamentals for spending are relatively sound. So while recent actual levels of retail spending – itself less than half of overall consumption – have clearly been weak, the outlook for total demand is less bleak. Nonetheless major retailers including Next, Kingfisher and John Lewis are saying that trading conditions are the worst they’ve seen since 1989.
Consumer spending likely to pick up, the question is when?
The household saving ratio continues to climb. In the second quarter it reached 5.0%, up from 4.1% in the last three months of 2004. We had been forecasting the savings ratio to rise, and our central expectation is that it will increase further in the next few years. A slower housing market, focus on pensions and higher debt levels are all reasons for consumers to want to save more. This much-needed adjustment requires consumer spending to grow less than disposable income. However, this ‘adjustment’ should be temporary, assuming the labour market and income growth continue to hold up relatively well.
Recent pain on the high street puts the Bank of England in a tricky position. Further rate cuts in response to temporarily weak high street sales might prove unwise, with inflation already significantly above target. We expect annual real consumption growth to remain subdued into next year, below 2% on average, but expect some improvements in recent high street sales to materialize in the next couple of quarters. The MPC need to look ahead at where overall spending will be over the next year or two. On balance we suspect they will attach enough weight to the view that spending will pick up to leave interest rates at 4.50%. But it may be close.
By Melanie Baker, Vladimir Pillonca and David Miles, Morgan Stanley economists – as published on the Global Economic Foru