UK - MPC Minutes

25.02.2008 UK - MPC Minutes

On 20 February the minutes of the Bank of England Monetary Police Committee meeting was published. Eight members of the Committee voted to cut repo rate by 25 basis points to 5.25%. The ninth member - David Blanchflower suggested reducing interest rate by 50 basis points (chart 1).

In the Minutes the Committee members gave a special consideration to the widened spreads and increased yields of mortgage and asset backed securities. Subsequently it caused huge losses for many investment banks. They expressed their concern related to the aggressive actions of rating agencies, which lowered the ratings of thousands structured products and asset backed bonds. It contributes to the deepening of the crisis, as the banks started to sell (write off) securities, the markets of which has been “freeze”, due to very low or absence liquidity. It will be recalled that during the last years they readily provided high ratings to these instruments. In the end, it was impossible to finance “bad quality” mortgages by issuance of bonds backed by these loans. British Northern Rock actively treated debt market to finance his liabilities, therefore turned out to be on the verge of bankruptcy. Northern Rock management didn’t manage to find investors, in this connection the UK Government decided to nationalize this bank. However, compared with American banks the losses of British banks were much less during the second half of last year.

For mitigating the turmoil in financial markets major central banks realized coordinated intervention in order to provide short term liquidity. For that the Federal Reserve System lent 40bln USD to the European Central Bank for a month. This loan was meant for satisfying the needs of European banks in USD. The Federal Reserve System, Bank of England and Bank of Canada didn’t confine to providing liquidity and cut base interest rates. The Federal Reserve System acted very aggressively and lowered the federal funds rate by 125 basis points. It was the fastest cumulative reduction of interest rates during one month since 1990. Central banks actions, including Bank of England, have had a significant impact on the market, as short term forward rates dropped down below 5%. Moreover, most of the market participants are expecting one more cut in the second quarter of this year (chart 2).

Furthermore, yield curve shifted down during the last twelve months, mainly due to short term treasury bills. The latter’s price rise was related to the market participants expectations concerning the forthcoming reduction of interest rates.

The provisional estimate of GDP growth in the fourth quarter had been 0.6% q/q, which is close to post World War II average rate. As during the first three quarters of 2007 this indicator fluctuated between 0.7 - 0.8 percent, GDP rose by 3.1% in 2007. One of the primary sources of economic growth was consumer’s expenditure, thanks to relatively high personal income. However, consumer confidence index rapidly fell during the last months. In January this index fell further to its lowest level since December 1992. It was connected with deceleration of personal income and house prices growth rates. In particular, all house prices indices have been falling a few months in a row. It is important to note, that growing house prices ensured an increase of consumers expenditure during the last two years. The impact of real estate on consumer’s behavior is too high, because the residential and commercial property worth exceeded 4trln pounds. At that more than half of this wealth is residential property.

175,000 jobs were created during the period of January-November 2008, which has been the largest rise since 1997. But in medium term the pace of employment growth has been moderate. The Bank of England experts explained this development in the following way: the National Statistics Online might have at its disposal an unemployed data among indigenous population, but not that of the migrants, who displaced domestic workers. We are keeping up with the demographic developments too, as immigration has a significant impact on the UK labor market. The UK able-bodied population strong growth is ensured by half a million immigrants from Eastern European states who joined the EU in 2004 (chart 3). This is the record level for the UK. As most of the migrants do low paid work and have families abroad the UK, in the short and medium term a significant part of their income is transferred to their relatives. Furthermore, more than three out of four migrants earn between 4.5 and 6 pounds per hour, whereas the average wage of natives is 10 pounds. Such a difference between wages holds back the earnings growth in the whole country.

Our forecast, related to the base rates reduction, proved to be correct. The Committee members voted to cut repo rate due to the crisis in the US Sub prime and Alt-A mortgage backed securities market, which had a negative impact on the UK real estate and mortgage markets (chart 4). Due to this crisis many British banks had huge losses, while one of them was on the verge of bankruptcy. These developments pushed down real estate prices and reduced monthly mortgage payments. The latter’s contraction came out of relatively high mortgage rates and tighten credit conditions, which were caused in their turn by “freeze” mortgage backed bond market. It will be recalled that for mitigating the US real estate crisis negative effect Bank of England attempted several actions, including cutting of base interest rate, providing huge liquidity and directly supporting the big bank, which was on the verge of bankruptcy.

Despite the intensifying crisis in the real estate market oil prices are still at record high levels, since this sharp rises have a political character and came out of Iran’s nuclear project and recognition of Kosovo independence. Another source of inflation acceleration will be money supply (M4), which edged up by 12.9% y/y in January.

Nevertheless, inflation growth rate remains within 2% due to significant decline of natural gas and electricity prices. In respect to the medium term economic cycles the increase of workforce thanks to immigrants from Eastern Europe will also have a downward pressure on inflation. Therefore, in case the representatives of the Bank of England give the above mentioned negative factors a consideration, it is possible that on May 2008 repo rate will be cut by 25 basis points.

UK ECONOMIC INDICATORS

Chart 1

Source: Bloomberg

Chart 2

Source: Bloomberg

Chart 3

Source: National Statistics Online

Chart 4

Source: Halifax, Nationwide

25 February