M. Ziauddin

The Bank of England on Wednesday predicted a sharp rise in inflation in the coming months, possibly to above three per cent, reducing the likelihood of an aggressive series of interest rate cuts.

In the bank’s quarterly inflation report, Governor Mervyn King said that hikes in the cost of household gas and electricity bills, as well as food, would push inflation up to the level whereby he was required to write a letter to the Chancellor explaining why.

He said: “The near-term outlook in today’s report is one of inflation rising sharply alongside a marked slowing in growth. The Monetary Policy Committee’s aim is to bring inflation back to the two per cent target in the medium- term. But in doing so, it faces a difficult balancing act.”

Mr King said that the outlook for UK consumer price inflation had significantly worsened since the bank’s last quarterly report in November.

Also citing disruption to global financial and credit markets, softer consumer spending growth and a deteriorating climate for investment, the bank said, risks to economic growth are weighted to the downside.

Earlier on the same day, the Office for National Statistics reported that unemployment fell 61,000 last month to 1.61 million. The number of people claiming unemployment benefit also dropped by 10,800 to 794,600, its lowest level since June 1975.

These figures showed that the labour market was still strengthening, suggesting that consumer spending may not shrink as much as some retailers fear.

Meanwhile, according to the OECD’s Composite Leading Indicators (CLI) a weakening outlook is indicated for all the major seven European economies. The CLI for the OECD area fell by 0.3 point in December 2007 and was 2.1 points lower than in December 2006. It decreased by 0.4 point in December and stood 2.2 points lower than a year ago. The CLI for the United Kingdom fell by 0.2 point in December 2007 and it was 0.1 point lower than a year ago. For France, the CLI decreased by 0.4 point in December and was 1.1 point lower than a year ago. The CLI for Germany fell by 0.1 point in December and was 2.4 points lower than a year ago. For Italy, the CLI decreased by 1.2 point in December and stood 3.4 points lower than a year ago.

December’s French and Italian industrial production data, released last week, provided yet further evidence of a slowdown in activity in the euro-zone’s major economies, with Italy in serious danger of dropping into recession. While the euro-zone still looks to be just about on track to grow by 0.4 per cent q/q in Q4, the continued softening in the activity data supports the view that the European Central Bank will be cutting rates by the summer.

The 0.5 per cent monthly fall in Italian production was the fourth consecutive monthly decline and pushed the annual rate of production growth down to a disastrously weak -6.4 per cent, its lowest rate since December 2001. In Q4 overall, production dropped by 2.2 per cent, the weakest outturn since Q2 1996.

It is quite clear that the underlying trend in Italian industry is very weak indeed. Having defied concerns about its lack of competitiveness over the last two years, it now appears to have succumbed to the strong euro and global slowdown. Coupled with evidence pointing to slower growth in the services sector, the numbers suggest that Italian GDP contracted in Q4 for the first time since Q1 2005. The Capital Economics (CE) has pencilled in a 0.4 per cent decline compared to our previous forecast of a flat outcome.

At best, this suggests that the risks to the consensus forecast of 1.2 per cent GDP growth in 2008 are on the downside. At worst, it might mean Italy is already in recession.

By contrast, French industrial production rose by 0.7 per cent m/m in December, broadly in line with the consensus forecast but not fully reversing November’s fall. In Q4, production rose by 0.3 per cent q/q – a sharp slowdown after Q3’s 1.2 per cent gain. Nonetheless, with the services surveys holding up well, the CE still expects French GDP to grow by a reasonably solid 0.5 per cent q/q in Q4.

February’s surprise rise in the German ZEW index provides some encouragement that investors do not expect recent stock market falls to do too much damage to the real economy. Despite rising to -39.5 from -41.6, the headline economic expectations index remained at a very low level – the long-run average is +31.4. And a sharp fall in the current conditions index left it at an 18-month low of 33.7.

While the index remains at a high level, consistent with very strong German GDP growth for now, it has tended to lag behind the hard GDP data in the past, and investors clearly think that the recovery is far past its peak. Nonetheless, the surprising upturn in expectations, taken together with the recent stronger-than-expected industrial production data, suggests that the German economy might be bearing up better than many expected.

Data from the largest four euro-zone economies combined suggest that overall euro zone industrial production increased by 0.4 in December and by 0.3 per cent in Q4 as a whole, softer than the CE said it was previously thought. While, the euro-zone still looks to be just about on track to grow by 0.4 per cent in Q4, the further softening in the activity data supported the view that the European Central Bank will soon switch to easing mode.

Meanwhile, in a surprise move the Swedish Riksbank’s decided to raise interest rates from 4 to 4.25 per cent (there had been a unanimous expectation of no change). This is said to have confirmed that it remains pretty concerned about the outlook for inflation. The Riksbank signalled back in December that it was likely to hike rates again, but the weaker news on the global economy was expected to keep it on hold. In the event, the Riksbank has stuck to its previous forecasts of fairly solid GDP growth of 2.4 per cent in 2008 and two per cent in 2009. Its inflation forecast for this year fell slightly, but that for next year rose a touch to 2.5 per cent - well above the two per cent target.

Meanwhile, the interest rate profile is also little changed from its previous projection, implying that rates are now on hold for an extended period. The CE thinks slowing growth will prompt the Riksbank to cut rates before the end of this year. For now, though, the move will clearly put upward pressure on rate expectations and the Krona.