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RBS: Glass half empty at Bank of England

Written by Roberta Murrat and Andrew McLaughlin, Chief Economist, RBS

Monday, 17 November 2008

RBS warns that further lower interest rates are unlikely to be enough to steer the economy back to sunnier shores.

RBS (LON:RBS) has today, in their Chief Economists Weekly brief, said that they expect further interest rate cuts to be implemented by the Bank of England (BoE), but that the cuts were unlikely to steer the UK economy into positive territory.

Group Chief Economist Andrew McLaughlin has said, "the glass is most definitely half empty at the Bank of England. The Bank used its latest Quarterly Inflation Report to acknowledge that it had been too optimistic about the UK’s economic prospects."

The revised forecast for a 1.3% contraction in activity in 2009 is significantly more pessimistic than the consensus among independent forecasters.

If the Bank Rate was held at its current level (3%), the BoE suggests that there is a 20% chance of inflation turning into deflation next year.

Inflation has fallen in every major post-war recession - this one won’t be any different says McLaughlin.

Further rate cuts are on the cards, and according to RBS predictions the next reduction is coming in December.

But lower interest rates are unlikely to be enough to steer the economy back to sunnier shores.

Even Mervyn King, the central bank’s Governor, has come around to this view. He said that it was “perfectly reasonable” to inject public money into the economy in such dire times.

Sterling takes a knock

The market reaction to Mr King’s comments and the downbeat tone of the Inflation Report was swift and unambiguous – sterling was sold heavily in foreign exchange markets.

Most notably, the pound dropped to £0.86 against the euro, taking the depreciation against the single European currency over the past year to 20%.

Hit to UK households gathered force.

Now that we know that the UK economy has started to contract, it’s not surprising that conditions in the job market took a marked turn for the worse in the three months to September.

The unemployment rate edged up to 5.8% from 5.7%, driven by an additional 140k people looking for work. Things will get worse before they get better. Vacancies - a good leading indicator - dropped by 53k in October, the largest decline since September 2001.

With house prices continuing to fall, consumers are facing bleaker income and wealth prospects, so it’s no surprise they are cutting back on spending - bad news for sectors that rely on discretionary spending.

In the US, retail sales plunged by 2.8% in October, the largest monthly decline in the history of the series. As the labour market continues to deteriorate, with the unemployment rate hitting a 14-year high of 6.5% in October, so consumers are reining in spending.

Real consumer spending posted its first quarterly decline since 1991 in Q3, but October’s retail sales figures suggest Q4 will be even worse. It’s looking increasingly likely that we will see three straight negative quarters for the first time since World War II.

Treasury Secretary Paulson announced measures to try and improve consumers’ access to credit, which could provide some support at the margin. Mr Paulson noted that 40% of US consumer credit is provided through securitization (where loans are packaged up and sold to investors), but that this market has been closed for the past few weeks.

Part of the $700bn Troubled Assets Relief Plan will be used to support the asset-backed securities market which should help consumers access finance.

Despite ECB President Trichet avoiding the use of the “R” word just two weeks ago, the Eurozone slipped into recession last
week.

The Q3 figures showed that the Eurozone contracted by 0.2% q/q in Q3, the second consecutive quarterly decline. Germany
and Italy both shrank by 0.5% q/q. The Spanish economy contracted by 0.2%, the Netherlands stalled and France managed a meagre 0.1% q/q growth.

More recent industrial production figures show that further weakness lies ahead. The European Commission and ZEW surveys sent equally disheartening messages. The only positive is that inflation is heading lower too - CPI was flat or falling in all of the major Eurozone economies, thanks to lower energy prices.

With all this in train, global leaders of the G20 (G7 plus 13 emerging economies) met at the weekend to discuss ways to prevent the global downturn from becoming protracted. Governments agreed to use fiscal measures to stimulate domestic demand, increase transparency and supervision in financial markets, and let developing countries have more of a say in key multilateral institutions like the IMF.

In the words of President Bush, "a meeting is not going to solve the world's problems", but action is coming. China is already taking aggressive measures, announcing a four trillion yuan ($585bn) stimulus package last week.