Demystifying UK’s Economy

Remember the latest BOE statement when the pound took a great fall like Humpty Dumpty did when he sat on that wretched wall? That was when BOE Governor Mervyn King decided to expand the bank’s quantitative easing (QE) program by £50 billion to £175 billion, while leaving its key interest rate at a low of 0.5%. The BOE seemed to be highly displeased with the UK’s current economic situation that they decided to up the ante of their QE program by an additional £25 billion!

All the King’s horses and all the King’s men now seem to be scrambling to get their act together again… Come to think of it, what good could come of a weaker pound? I can think of two: Inflation and currency strength.

Let’s start with inflation.

The latest Consumer Price Index showed that the inflation remained steady from the last reporting period at 1.8%. Lower prices of food, furniture and household equipment prices were the primary factors in holding inflation below the bank’s desired 2% rate. Still, even if UK’s prices have been rising nicely in contrast to that of the US and Euro zone, UK is certainly not out of the woods yet. The possibility of deflation still lingers as the rise of general prices remains slow. The expansion of its QE program could also be viewed as an ‘insurance policy’ following the recent discouraging UK GDP report.
And there’s the recent pound strength…

The appreciation of UK‘s domestic currency due to increased risk appetite in the capitals markets is making it hard for the economy to pull itself out of the slump. Weakening the pound would counter the negative effects of Labor Party Prime Minister Gordon Brown’s deficit spending and hopefully boost the country’s export industry.

With the threat of rising inflation virtually non-existent, there was hardly any reason for the bank’s Monetary Policy Committee to decide against expanding their bond purchase program. Doesn’t hurt to give the economy a little more push, right? But does it really need one?

Manufacturing production bounced up by 0.5% in July after sliding down by 0.6% in June. Business confidence is also improving, based on the recent manufacturing, construction, and services PMI data. Manufacturing PMI climbed from 47.4 to 50.8, beating the consensus at 47.7, as manufacturing activity expanded for the first time since 2008. Services PMI stayed safely above the 50.0 expansion mark as it stepped up from 51.6 to 53.2 while construction PMI landed at 47.0 from 44.5 in the previous month.

Moreover, house prices were up by 1.1% in July while a total of 8.1% of surveyors reported house price declines in their area. These better-than-expected data led to increased speculations that the UK housing industry has bottomed out and is making its way back up. Consumer spending is also on a roll, with same-store sales rising by 1.8% last month, buoyed by higher demand for furniture and home goods. This uptick in spending suggests that consumers are more confident with their financial standing as well as the nation’s economic outlook. Nationwide, the largest building society in the world, reported that consumer confidence edged up from 59 to 60 in July.

Of course, what good is an economic story if adversaries aren’t present? Well, rising unemployment is dampening hopes of a strong economic recovery since the prospect of more job losses forces consumers to cut back on their spending. The nation’s unemployment rate climbed from 7.6% to 7.8% as the Claimant Count Change recorded a total of 24.9K job losses in July. This puts downward pressures on retail sales, which were up by 1.2% in June. Also, producer prices fell down by 1.4%, their sharpest drop in almost 8 years. This suggests that headline inflation could remain below the BOE’s target for quite a while…

Given all this fuss about inflation, what’s next for the pound? Well, it all depends on risk sentiment. Heh, if were given a nickel whenever economists out there mention that I’d be a gazillionaire by now… But I digress so let me get back to the point!

The thing is, whenever good data comes out from the UK, the pound is normally given a boost. Heck, people have been buying it up even on “not-as-bad” news. This relationship was seen quite clearly when the pound jumped 50 pips versus the dollar yesterday when the CPI, despite lower than the BoE’s desired rate, was better-than-expected. Aha! People jumping on “not-as-bad” news!

With inflation approaching the BOE’s 2% target rate, we might see investors and traders become more optimistic towards the UK economy, which in turn, could boost the pound further. After all, it seems that markets are still being propped up by risk sentiment as opposed to fundamentals. If it were otherwise, I would be concerned about the pound’s overall strength (ahem, weakness)…

Daily Economic Commentary: United Kingdom
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