The Bank of England’s (BoE) Monetary Policy Committee (MPC) voted not to change course in June. Leaving the Bank rate at 0.5% and its quantitative easing programme at £375bn, the reign of Governor King at the helm of the MPC since its first meeting in June 1997 came to a quiet end. The previous four meetings had seen a 6-3 vote against additional quantitative easing (QE), but improving economic data snuffed out any chance of a vote change. April saw a larger than expected fall in CPI inflation to 2.4%, from 2.8% and business survey data for May suggested activity expanded at its fastest rate in more than a year in both the manufacturing and services sectors. Even construction output was up for the first time since last October. These improvements provide the distinct possibility of an acceleration in Q2 growth. Inevitably, the focus will shift towards the sustainability of this new momentum – not least because of the continued problems in the Eurozone. It also raises questions about the extent of monetary policy activism by Mark Carney when he takes the BoE helm in July.
The Federal Open Market Committee (FOMC) meets in two weeks time and will have a lot of positive data to interpret. The housing market is well on the road to recovery - prices are up 11% on a year ago and the overhang of foreclosed properties down 24%. Higher prices will help the US economy both directly - as it stimulates construction activity, and indirectly - as prices rise fewer people will be in negative equity (where a house is worth less than the loan secured against it). In turn, this should improve the labour market. With fewer households in negative equity we’d expect labour mobility to increase as it allows those unemployed to widen their search for work.
Better economic data have led to expectations that the Federal Reserve will start to alter its policy settings. Markets have reacted with 10-year treasuries now yielding over 2.1%, up 0.5% in just a month. But with weak inflation and continued uncertainty around the fiscal situation we think the Fed will remain steady for a little longer. Last week revised data showed that government spending cuts wiped a full percentage point off GDP growth in Q1. That’s a big drag irrespective of what happens with monetary policy. If the Fed decides to slow the pace of asset purchases, we think it’s unlikely to be before September.
As expected, the European Central Bank (ECB) kept rates on hold at 0.5% at its June meeting, after a 25bps cut in May. Some recent speculation suggested that the ECB might push forward on other stimulus fronts, but President Draghi held back – for the time being at least. More action by both the ECB and national governments will be needed to support the beleaguered Eurozone economy as the second estimate of Q1 GDP confirmed that the euro-area recession deepened in the first three months of the year. Investment contracted as credit conditions remain tight, while falling exports also detracted from growth. Unfortunately, as the region continues to struggle, the recession looks set to enter its seventh straight quarter. Forward looking indicators improved slightly in May as the purchasing manager’s index (PMI) for manufacturing rose to 48.3 from 46.7 and the gauge for services edged up to 47.2 from 47. Being below 50, these indices continue to signal a contraction in activity, rather than expansion, but at least the rate of contraction is slowing.
ECB President Mario Draghi insists that despite the “challenging” economic outlook, growth in the euro area will pick up later in the year. But this mantra is becoming harder to believe as the ECB again revised down GDP projections for 2013 to -0.6% from -0.5%. Acknowledging that too much austerity is detrimental to growth, the European Commission granted Spain and France two extra years to get their budget deficits to less than 3% of GDP and the Netherlands an additional year. The scrutiny of Italy’s finance’s was also eased. Good news for politicians. But with unemployment now at 12.2% and almost one in four people under 25 years of age out of work, confidence remains poor.
We are creeping towards unfamiliar territory in the US as speculation increases about when the Federal Reserve will start to reduce its QE purchases. This follows six years of unprecedented monetary stimulus, ranging from aggressive rate cuts in 2007 to open ended asset purchases more recently. While rate hikes and a full blown exit from QE remain a long way off, the strength of the US recovery has allowed the Fed to start contemplating a gradual return to a more normal monetary policy setting – something far from the minds of ECB and BoE policy makers as their economies lag the recovery across the Atlantic. From a currency perspective this clearly favours the dollar. But we don’t think the Fed will start to moderate its QE purchases until at least September which would support a move south in GBP/USD into the 1.40s, and EUR/USD into the mid-low 1.20s in the second half of 2013.
The recent decline in the Japanese yen has come to a halt, following a 30% fall against the dollar and 35% against the euro. A weaker currency is a key rung in “Abenomics” - the Japanese Prime Minister’s strategy of ending 25 years of economic malaise. Against a trade weighted basket of currencies the yen is at levels not seen since 2007, a year in which the Japanese economy grew 2.2% supported by export growth of 8.7%. This was achieved against a backdrop of global trade growth of c8%. Exporters will have to compete with trade growth around half of that rate in 2013. In the current economic environment it seems unlikely a depreciation will give you as much bang from your buck.
This material is published by The Royal Bank of Scotland plc (“RBS”), for information purposes only and should not be regarded as providing any specific advice. Recipients should make their own independent evaluation of this information and no action should be taken, solely relying on it. This material should not be reproduced or disclosed without our consent. It is not intended for distribution in any jurisdiction in which this would be prohibited. Whilst this information is believed to be reliable, it has not been independently verified by RBS and RBS makes no representation or warranty (express or implied) of any kind, as regards the accuracy or completeness of this information, nor does it accept any responsibility or liability for any loss or damage arising in any way from any use made of or reliance placed on, this information. Unless otherwise stated, any views, forecasts, or estimates are solely those of the RBS Group’s Group Economics Department, as of this date and are subject to change without notice. The classification of this document is PUBLIC. © Copyright 2012 The Royal Bank of Scotland plc. All rights reserved.