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November rate rise – says RICS

A solid economy will lead to another rate rise in November, the Royal Institute of Chartered Surveyors has predicted.

In RICS UK economic brief for September the surveyors believe UK economic growth has recovered from the weakness of early 2005 and the UK economy is growing solidly, driven in most part by consumer spending in the past year.

Despite fears over debt levels and utility costs, consumer spending should continue to grow, albeit at a slower pace than in the second quarter, supported by a healthy labour market.

Manufacturing output is also enjoying a revival, supported by climbing export and business investment. Indeed, with global growth forecast to remain robust it is likely that the Bank of England will choose to raise interest rates again before the year ends.

The U.K. economy grew 0.8% in the second quarter and 2.6% over the past year. These results confirm an acceleration from the first quarter's 0.7% quarterly rise and 2.3% on the year outturn. The economy is now growing almost exactly at trend pace, that which is considered to be consistent with stable inflation at the government's target rate of 2%.

Household demand, which accounts for over 62% of the economy, was the primary driver of growth during the past twelve months. Private consumption rose by 2.4% on the year, marking the strongest annual rate of expansion since the fourth quarter of 2004. Government consumption was up 2.0% year on year. However, growth has been balanced with gross fixed capital formation jumping by 6.3% over the year, as business ramped up investment in response to rapid global economic growth and buoyant demand for UK exports that have helped manufacturing recover from a difficult 2005.

It was the strong economic growth picture, and above target inflation which persuaded the Bank of England to raise interest rates in August by 0.25%, the first change in exactly a year.

Inflation looks set to cause worries for the BoE as figures for August were running 0.5% above the government's target. Of further concern to the BoE is the recent strength of consumer perceptions of inflation, which could feed through into higher wage demands. Indeed, the old inflation measure, RPIX, which the BoE used to target, is the highest since 1993 and almost 1% above its target of 2.5%. While the BoE's August rate rise and the recent declines in the price of oil (which should lead to falls in household utility bills) should lead to an easing in consumer price expectations, the BoE may decide another rate rise is necessary to ram the message home that it is serious about keeping inflation low. Key in this regard is the strength of the underlying economy. Most importantly the consumer.

Retail sales, a major component of consumer spending, enjoyed an excellent period between March and June which saw volumes increase 0.7% per month for four consecutive months. Commentators were suspicious about the influence of the World Cup during this period, and many predicted a weaker third quarter as high debt service costs and rising utility bills constrain the growth in consumer demand. Yet while there has been a modest slowing in retail sales growth during July and August, the consumer has not retrenched as feared. Indeed, the annual growth rate has continued to rise, hitting the highest levels since the end of 2004 on an underlying basis.

For this strength to continue, the labour market must perform well. During the last twelve months, growth in average earnings excluding bonuses has fluctuated between 3.5% and 4%, significantly below the average between 1997 and 2005 of 4.2%, despite accelerating economic growth. But will this weakness continue? There are two competing theories. Firstly, large immigration flows and higher labour force participation rates in older generations have boosted the labour force (rising at the fastest rate since late 1984). This has created slack in the labour market and allowed unemployment to rise even as the economy has continued to create a significant number of new jobs. Indeed, whilst the number of unemployed has increased by 305,000 since November 2004 (the month unemployment began to rise), employment has grown by 488,000 (1.7%) and the labour force has expanded by 792,000 people (2.7%).

Secondly, the BoE is worried that wage growth will pick up sharply as other costs to firms subside. Its reasoning is that there has recently been an inverse relationship between domestically generated inflation (of which wages are a key driver) and external inflation, which has been boosted by rising energy and commodity prices on world markets. Raw material prices for manufacturing firms have certainly begun to pare back the rapid gains seen earlier in the year, rising 9.6% in the year to August compared with a 16.1% rise in the twelve months to January. There is clearly a possibility that as the pressure on firms' operating margins subsides somewhat, wage growth may recover.

RICS think that there is a foundation for rising wages and higher consumer spending levels, as employment is set to continue rising at a good pace. Demand for labour seems to be recovering with vacancies up over 5% since their trough in October last year to stand above their long run average. In addition, present robust economic growth will generate further demand for labour in coming quarters.

Consumers will also be feeling a positive boost from the performance of the UK housing market. After a weak first half of last year, the August 2005 interest rate cut and a general economic recovery reinvigorated the market.

Activity levels as measured by mortgage approvals have increased to significantly above their decade average of 102,000, to 120,000 in August. This year has seen an acceleration of house price growth with the RICS forecasting that prices will rise by 7%, after a 3% rise in 2005. Along with the housing market recovery, mortgage equity withdrawal, the amount of equity home owners release from their property, has also recovered from a low of 3.2% of post-tax income in 2005 Q1 to 5.8% in the first quarter of this year. As the housing market is expected to remain strong throughout the remainder of the year, consumer spending will gain support from significant amount of mortgage equity withdrawal.

If consumer spending were to hold up and the other parts of the economy stay strong, then one might imagine that the BoE will raise interest rates again. As mentioned above, manufacturing has recovered on the back of rising export demand in the expanding global economy. A significant increase in the amount of basic goods produced (like steel) suggests further growth in capital and consumer goods, but survey evidence may be pointing to a plateau in manufacturing growth. When it comes to business investment and exports, the signals are mixed.

The activity data point to good growth in business investment, but this masks a big drop off in manufacturing investment in Q2. However, less volatile surveys of manufacturers show investment activity is buoyant. Similar confusion surrounds exports. While official figures show a rapid slowing in export growth, survey data indicates continued strength albeit a slight easing from the pace in the first quarter. A strong global economy should support exports going forward. The International Monetary Fund has just raised its forecast for global growth in 2006 to 5.1%. This robust growth should help propel the UK economy and convince the BoE that another rate rise this year in warranted, most probably in November of 0.25%.

Residential property

The latest figures from RICS showed that house price growth accelerated for the fifth consecutive month in August, hitting the fastest pace since May 2004. This fits in with the latest Bank of England data on mortgage approvals, which shows strengthening demand for mortgages. Price rises are being driven by a combination of new buyers entering into the market and a standstill in new property supply. 

Buyer enquiries rose for the fifteenth consecutive month in August, up at the fastest pace since September 2003. Completed property sales for the past 12 months have also risen firmly as stronger buyer interest fed through to final transactions.

New instructions to sell property showed little change in August as the holiday season has come to an end.

Above trend economic growth, driven mainly by consumer spending, combined with a strengthening employment and wage picture is supporting buyer confidence. Buyer enquiries are also being supported by rising first-time buyer (FTB) accessibility, with an upturn in loan-to-value ratios enabling more to enter the market as the required deposit diminishes compared to income levels. Loans to FTBs rose by 20% in the first seven months of the year compared to the same period a year ago, although FTB accessibility still remains low by historic standards.

In spite of this recent improvement in FTB accessibility, the combination of August's quarter point interest rate rise and annual house price inflation (6% by the official government measure) far outpacing average earnings growth (4.4% as measured by the three month moving average), will further diminish FTB housing affordability., as the initial debt servicing cost of a mortgage rises.

August's quarter point interest rate rise has yet to impact on prices and buying activity. The prospect of further monetary tightening has dampened surveyors confidence a touch in the short term, although the mood still remains upbeat.

Expectations for price rises over the next three months are close to this year's high point, and surveyors are anticipating a strong autumn selling season. Further increases in the base rate will cool the housing market.