Economics Weekly

Round-up A quiet week for global data meant that all eyes were on the Fed Chairman Alan Greenspan, giving his bi-annual testimony to congress on Wednesday. As expected, he reiterated his cautious optimism on the economy but did little to alleviate any fear of deflation, noting that any further substantial fall in inflation would be "unwelcome". As the administration now has officially abandoned any remnants of its strong Dollar policy following this week's remarks by John Snow, dollar weakness may hold the key to avoiding deflation, at least in the US. Little sign of deflation meanwhile in the UK. Whilst there was only minimal change to the first estimate of Q1 GDP (up 0.2% q/q, 2.2% y/y), the second estimate revealed that the GDP deflator was up 2.9% y/y in Q1, with a notable 6% rise in the government component (are the recent tax rises simply being inflated away?). The medium term outlook for domestic inflation depends partly on the outlook for sterling – the implications of its recent fall on domestic pricing power are discussed below.

Viewpoint: Exchange Rates and Pricing Power.
Earlier this year, (Weekly - 21st Feb), we flagged the point that virtually all pricing power in the UK originated from domestic services, with the traded goods sector still in outright deflation. This week, we broaden the scope to briefly consider trends in the Eurozone before focussing on whether the recent fall in sterling is likely to redress this divergence between goods and services in the UK.

Chart 1 compares the broad breakdown of the harmonised consumer price indices for the UK and Eurozone. Whilst there are some specific differentials, the noticeable difference relates to deflation in UK core goods compared to, albeit modest, inflation in the comparable Eurozone measure. Whilst it is normal to expect lower inflation in goods (it is easier to realise productivity gains in producing goods that feed through into lower prices), the extreme situation in the UK is symptomatic of the wider imbalances prevalent in the economy today.

The pertinent question is whether the recent fall in sterling is likely to address this imbalance, reducing the strength of domestic demand and giving a much needed boost to our troubled manufacturing sector?

Chart 2 above would support this prognosis. The rising exchange rate in 1996/7 helped contribute to the increase in the terms of trade (the average sterling price of UK exports to imports) in the second half of the 1990s that helped support domestic demand (and therefore domestically generated inflation). Whilst this is not the full story , the fall in sterling would go some way to reverse this process. The chart above suggests that the divergence between goods and services could nearly halve (over the next 12 months) from a peak of over 5½% in 2001 if the exchange rate were to remain at this level. What does this mean for the wider economy? If the divergence were to close purely due to a rise in (imported) good prices, this might prevent the MPC from easing policy further, a problem if the consumer and housing market were to weaken significantly from here. However, their relaxed stance on sterling and this week’s Minutes (they voted 5-4 to keep rates on hold in May) still suggests a further 25 bps of easing over the summer. Our view is that the closing of the gap between goods and services will come from both sides. For fund managers seeking pricing power in the UK, this does have some implications. The retail sector, which is unlikely to be able to pass on the full cost of higher imported goods prices to a highly price sensitive consumer, is likely to be squeezed, while domestic manufacturers can expect some improvement in their pricing power.

RIP RPI?
Whilst on the topic of UK inflation, there has been speculation this week that the Chancellor will provide more detail on the 9th June (when he announces the results of the 5 tests) on a change to the inflation target (targeting HICP rather than RPIX), or even introduce it immediately. Assuming the target was changed from 2.5% to 2% , would this represent an implicit easing of policy? Prima facie, the answer is yes - the latest HICP rate was 1.5y/y% (vs a potential 2% target) as opposed to 3% RPIX (vs a 2.5% target). However, the MPC appears to be implicitly targeting ‘RPIX - special factors’ (mainly housing depreciation and council tax that take off 1% from current inflation). Thus, in practice, we think this change would be neutral for monetary policy, simply representing a longer-term pro-Euro gesture, given that the ECB and Bank of England would then both be targeting a 2% inflation rate.