Ramesh Sharma

June 1, 2004

The Bank of England Monetary Policy Committee (MPC) left the Base Rate unchanged at the September and October meetings. The vote at the September meeting was 9-0 which suggests that rates will be left unchanged for a while longer. Forward markets anticipate one further Base Rate reduction next year, probably in February or March.

We continue to hold the view that it will fall to 4 per cent by the middle of next year and remain at that level for some considerable time as euro zone and UK economies converge. Underlying inflation, at 2.4 per cent, is close to the top quartile of the target range.

The recent increase in oil prices will add further to inflationary pressures, both directly in the form of higher petrol prices and indirectly through the knock-on effect of higher oil prices on a very wide range of retail prices.

Decline in growth

The case for a further one or two Base Rate reductions lies with the decline in UK economic growth to 1.5 per cent year-on-year in the second quarter of 2005. This represents a growth rate that is 1 per cent below trend. Survey evidence and recent data suggest that the third quarter annual growth rate is not likely to show a significant improvement. The Bank of England is however likely to hold fire on the Base Rate until such time as inflationary pressures abate.

It is notable that the yield curve is starting to gradually steepen i.e. despite the prospect of a lower Base Rate; the five-year rate is marginally higher than the two-year. We expect this trend to continue. The decline in the two-year interest rate over the next few months is likely to be greater than the decline in the five-year rate where we see limited downside.

House price divergence

There is some divergence in house price data. The Halifax House Price Index rose by 1.6 per cent in August, increasing the annual rate of house price inflation to 2.5 per cent. The most recent Nationwide index showed a 0.2 per cent decline in September, reducing the annual rate of house price inflation to 1.8 per cent.

We suspect that the difference between the two indexes reflects not just the timing factor but also differences in the mix of business. It is quite feasible that the annual rate of house price inflation could fall further.

Nevertheless, the labour market remains resilient with unemployment under 5 per cent and average earnings close to 4 per cent. We continue to predict a soft landing for the housing market.

There is no sign of any reduction in the underlying level of mortgage lending. On a seasonally adjusted basis, net lending is currently running at an annualised level of between £80 and £90 billion. Gross lending is on target for a figure in excess of £250 billion.

These levels are significantly higher than many analysts were predicting at the start of the year. The resilience of the housing market, despite lower than forecast economic growth, reflects the longer-term optimism of the UK personal sector.

We are also upbeat about the outlook for the UK economy next year. We forecast it will return to trend growth of 2.5 per cent boosted by a reduction in the Base Rate to 4 per cent. We do not foresee any further reduction in the rate of average earnings or any significant increase in the rate of unemployment.

While there is likely to be a modest increase in the level of personal taxation next year, the need for fiscal tightening has been reduced by the redefinition of the economic cycle which enables the Chancellor to maintain public borrowing at a level higher than originally envisaged.

Laurance Sanders is economist at Bristol & West Mortgages

Recent key data (All year-on-year except if otherwise stated)

UK Underlying Retail Price Inflation Aug 2005 2.4%

UK Underlying Average Earnings July 2005 3.9%

UK Economic Growth Q2 2005 1.5%

UK Gross Mortgage Lending (secured Aug 2005 £23.9bn

on dwellings, seasonally adjusted)

UK Net Mortgage Lending (secured Aug 2005 7.6%

on dwellings, seasonally adjusted)

Nationwide House Price Index Sep 2005 1.8%

Brent Oil Price (1 month forward) End Sep 2005 $62 per barrel

Bristol & West predictions

Base rate fixed (semi annual) 2-year swap fixed (semi annual) 5-year swap

Current rate 4.50% 4.50% 4.60%

End 2005 4.50% 4.30% 4.40%

End 2006 4.00% 4.10% 4.30%

End 2007 4.00% 4.30% 4.50%

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