Research Dept. News
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Monthly Report, num 345 - April 2011
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European union - United Kingdom
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The United Kingdom: more inflation and more uncertainty regarding growth
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Inflation rises to 4.4% year-on-year.
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In mathematics, an equation is an equal sum that contains one or more unknowns. However, not all equations can be solved. This seems to be the current situation of the United Kingdom, where the two unknowns are consumption and public spending, which form part of the gross domestic product equation. Even the Governor of the Bank of England, Mervin King, admitted to the press that uncertainty had significantly increased regarding the future path to be taken by inflation and growth.
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However, we can restrict this level of uncertainty by selecting key variables on which economic activity will depend in the United Kingdom during 2011. These are: inflation, interest rates, the new fiscal budget and foreign trade. The importance of these variables lies in their impact on the net disposable income of households.
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Higher taxes and interest rates will reduce households' disposable income.
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Regarding inflation, the latest figures for the CPI in February showed a 4.4% rise year-on-year, the highest since October 2008, while core inflation was up 3.4%. Our forecast for inflation, which remains the same for 2011, is 4.0%.
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Which components push up inflation? There are several factors but two stand out. The first is the two and a half point rise in VAT from 17.5% to 20%, which took place in January. Secondly, the United Kingdom is not immune to price rises in oil and other commodities. So we cannot rule out inflation approaching 5% over the coming months. But it is very important to consider whether these impacts are permanent or temporary, and in both cases it is the latter. This is important because we expect British inflation to end the year close to 3.6% and that, in 2012, the base effect will help inflation to fall sharply, although this higher inflation will undoubtedly erode households' disposable income during 2011.
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Another key variable will be how the central bank reacts to the rise in inflation. The minutes published for one of its latest meetings shows a split in the Monetary Policy Committee. At the moment, the official interest rate is at 0.5%, and one member proposed a rise of 0.5%, another two voted in favour of a rise of just 0.25%, while another member preferred to increase liquidity through buying up assets and the rest decided that the best thing was to keep the official interest rate as it was.
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The risk for the United Kingdom is a downgrade in its economic growth.
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This situation reflects the uncertainty regarding growth in the United Kingdom. Given the bad growth figures for the fourth quarter, we believe the reserve bank will prefer to see the figures for the first quarter before taking any decision. However, it is likely that, around summer time, the United Kingdom will have a somewhat higher official interest rate. It's clear that this situation would lead, once again, to a reduction in consumers' disposable income, although this possibility has already been included in the price of money, as can be seen in the different curves for interest rates (public debt and interbank market) that have risen recently, incorporating this information.
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The other two most important factors are the new fiscal budget presented by the Chancellor of the Exchequer at the end of March and the trend in foreign trade. Regarding the former, it's important to know what the tax hikes will be to help the government achieve its goal of fiscal consolidation, as this will allow us to calculate the impact on families' reduced net income. On the other hand, the depreciation of the pound sterling, together with greater global growth, was expected to boost exports. Although the latest figures do not point towards an improved trade balance, higher prices for foreign products compared with domestic ones will encourage consumers to spend their money on the latter, helping this component to contribute positively to growth in the United Kingdom.
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Fortunately, over the next few months a large number of these unknowns will be revealed, so that we'll be able to determine the direction taken by economic activity this year and the next with more certainty. But we can already state that the risk is asymmetrical, insofar as it's more likely that we will have to lower our growth forecast for 2011 from 2.1%.
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