Time for some quiet reflection says ITEM

The Bank needs to blow away the froth in the market without resorting to overkill

London 23 July 2007: The new Chancellor and the MPC have to tread a careful line between keeping an eye on an over-exuberant City and a housing market that refuses to dampen down, without panicking into a series of damaging interest rate rises, according to the Ernst & Young ITEM Club Summer forecast.

ITEM is predicting strong GDP growth of 2.9% in 2007 and 2.5% for 2008 and expects interest rates to rise further, particularly if the activity in the markets gets out of hand.

Peter Spencer, Chief Economic Advisor to the Ernst & Young ITEM Club, explains, “Everyone is getting worried about monetary growth and interest rates. But, the economy is not going to take a tumble, particularly with the global picture so firm. The Bank has acted forcefully, but it now needs to be careful not to squeeze the UK economy too hard. The MPC needs to rebalance the economy and cool the housing and financial markets, without jeopardizing exports.”

Interest rates will stay high

ITEM expects interest rates to move up to 6% and then stabilize, which Spencer believes should be enough to halt the excesses in the housing market. Gas and electricity are now bringing down CPI inflation, which is likely to fall back towards the 2% target this autumn, giving the Bank breathing space. Spencer says, “Whatever the timing of any further tightening, it now seems clear that we are all going to have to get used to a period of significantly higher interest rates. Our forecast therefore assumes that interest rates will rise to 6%, possibly as soon as August. What happens then depends on whether people take heed of these rate rises and adopt a more cautious approach to their personal finances.”

Storm clouds are gathering across the Atlantic

The uneven performance of the American economy is cause for concern for ITEM, particularly the US housing and mortgage markets. Core US inflation remains high, diminishing the scope for interest rate cuts as the housing and mortgage markets continue to menace the consumer. Although there are big differences, ITEM warns that the UK could just be lagging behind the US and that financial regulators and the MPC will need to monitor these developments very carefully.

Spencer adds, “The UK should be able to withstand a slowdown in the US and wobbles in its housing market. Currently, these problems are US specific and should not spread. Luckily, we have not seen the standstill on real wages that they have - at least not yet. And they did not see the same growth in the money supply and house prices that we have.”

The party in the City is in full swing but the music may soon have to stop

World demand for business and financial services continues to surge and is a major driver of growth in the UK. However, the current UK expansion is becoming too dependent upon the performance of these sectors and the financial market activity associated with lax credit and monetary conditions.

Spencer says, “Our worry is that the buoyancy of the business and financial sectors will continue unabated, and that rates will need to be raised further to subdue this exuberance. If that happens, the housing market and the high street will be very exposed. These developments have the potential to cause a major slowdown in the consumer sector. However, the shake-out from the US sub-prime market has raised the cost of debt to hedge and private equity funds and this is likely to slow the pace of M&A activity. With a bit of luck, this will just blow away some of the froth at the top of the market.”

Britons feeling the pinch

The belt-tightening situation is compounded by fiscal drag bearing down heavily on disposable incomes, pushing the tax burden up towards record levels. Household tax payments increased by 9.8% in the year to the first quarter, well ahead of the growth in pre-tax income. This squeeze has virtually eliminated the growth in real disposable income.

Spencer says, “With warnings of yet higher interest rates and financial problems round the corner, ITEM expects prudence to prevail. There are around two million people on fixed mortgages which expire later this year. When they took out their fixed-term mortgage, base rates were around 4 ½ per cent; when the term comes to an end rates will be 6% – that’s a big hike and that will put a real dent in people’s pockets.”

More rain for the High Street?

ITEM predicts consumer retrenchment even before the unwinding of numerous fixed-rate mortgages. With low macroeconomic risks dramatically increasing the appetite for debt, consumers are dipping into savings. The saving ratio fell back to 2.1% in the first quarter – lower than at any time since 1960.

Spencer concludes, “Hard-up consumers will begin to rein back on their spending. However, thanks to the resumption of real income growth as employment and earnings improve and energy and utility prices fall back, we expect a recovery in the saving ratio to 4% by the end of this year and 5% by the end of 2008. Employment and earnings have been surprisingly weak in recent months, but recruitment surveys suggest that they are set to strengthen. On this view, real disposable incomes are set to grow by 3.1% next year, while consumption growth will slow to 2.2%.”