British Labour Government Faces Mission Impossible

May 14, 2008

Although U.K. parliamentary elections are not required until the middle of 2010, Prime Minister Brown’s chances of retaining power look hopeless. His party just suffered its worst beating in local elections in 40 years, and his voter approval rating has collapsed since he took over from Tony Blair about a year ago.

Little is going right in the British economy, and it shows in the marketplace. The trade-weighted pound has dropped 12.5% since peaking last July. Three-month term rates of 5.81% are well above the current central bank rate of 5.05% and even higher than the latter’s 5.75% level last July. The yield on ten-year Gilts remains elevated at 4.80%, well above its Euroland and U.S. counterparts of 4.16% and 3.96%. The housing market bubble is deflating rapidly. One policy committee member at the Bank of England expects house prices to fall as much as 30% from peak to trough. Already, double-digit house price inflation in mid-2007 has been transformed into negative on-year percentage changes. Mortgage approvals last month plumbed to a 16-year low, and total net bank lending is near a 6-year low. Real GDP grew 2.5% in the year to 1Q08. However, that preliminary estimate is likely to get revised downward, and the Bank of England now expects such to drop to 1.0% by 4Q08 and take until mid-2010 before returning to 2.3%. The British PMI-services score of 50.4 in April was the lowest reading since May 2003 and down abruptly from 54.0 in February. The manufacturing PMI of 51.0 connotes weakness, too. Real retail sales slid 0.4% m/m in March, and the CBI distributive trades index in April (-26) hasn’t been lower since November 2005. British consumer confidence is at a 4-year low by one gauge and at a 15+ year trough according to another.

The Bank of England is prevented from loosening monetary policy aggressively by the weak pound, above-target inflation, and elevated expected inflation. Until ten days ago, a rate cut in June or July was considered a lock, and now it looks like rates might not even be reduced further this year. The Bank of England foresees the CPI rising from 3.0% currently to 3.7% by 3Q08 and remaining above 3.0% for a considerable time to come. If the Bank rate is cut along the lines of present market expectations, officials predict that inflation will still exceed target two years from now. If the Bank rate is held unchanged at 5.0%, inflation will slide just marginally below the 2.0% target according to a baseline forecast whose risks are skewed to the upside. Other widely watched price measures show twelve-month increases of 23.3% (producer input prices), 7.5% (producer output prices), and 4.2% (retail prices). Average earnings, a measure of wages, rose 4.7% in the year to March, its greatest advance in 14 months and above the central bank’s comfort ceiling of 4.5%.

Britain’s economy has several vulnerabilities. The current economic expansion is long in the tooth. Financial services have accounted for a disproportionate share of growth during that expansion. Public finances are not in great shape, with a budget deficit most likely surpassing 3.0% of GDP this year, so scant scope exists for fiscal support as well as monetary stimulus. A large and chronic external deficit persists in spite of the retreat in sterling. A current account gap of between 3.5% and 4% of GDP is likely this year and next. The quality of political leadership is not inspiring the confidence of either households or the business community, but new blood and ideas may not be in place for another two years.



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