UK Price Pressures Signal Stagflation Risks

The U.K. faces the risk of stagflation with the economy set to slow significantly against a backdrop of relatively strong pricing pressures, a report by a leading business lobby group found Thursday.

The British Chambers of Commerce's quarterly economic survey also recommended that the Bank of England's Monetary Policy Committee cut interest rates at its meeting next month to avoid the need for sharper rate moves ahead. "Relatively strong price pressures, though below the peaks (seen in the fourth quarter of 2006), signal risks of stagflation," the BCC survey found. "The U.K. economy is set to slow markedly, and small firms could face problems," it said, adding that prospects for the economy had worsened following the credit crunch. Economic growth in the U.K. hit an annual 3.1% in the second quarter of this year, and the government expects it to average a robust 3.0% over 2007 as a whole. But in his pre-budget report published Tuesday, U.K. Chancellor of the Exchequer Alistair Darling tipped economic growth to slow markedly to between 2.0% and 2.5% in 2008. The BCC tips gross domestic product to grow 2.0% next year. But, Deutsche Bank U.K. economist George Buckley, who was present at the BCC press briefing as guest analyst, said stagflation was a loaded term that conjured up images of runaway prices and little or no growth. The reality, for the moment at least, is below-target inflation and above-trend economic growth. "This may be the end of the so-called NICE (non-inflationary, consistently expansionary) decade," Buckley said. "To my mind this is not a period of stagflation, but the tradeoff between inflation and growth will likely worsen," he said, adding he predicted a 15%-20% chance of recession in the U.K. over the coming cycle. Buckley tips a rate cut in the middle of the first half of 2008. The BCC survey highlighted an increase in demand in the manufacturing sector, where the net domestic sales balance lifted to 36% in July-September from 31% in the previous quarter. That result matched a record high in the series, which began in 1989. But figures for the dominant U.K. services sector were less upbeat, with the net domestic sales balances dropping seven points to 29%. Domestic orders also worsened somewhat in both manufacturing and services, and the services export orders and sales balances fell to their lowest levels since the fourth quarter of 2004. "The results of this survey show that the MPC must cut interest rates in November," said David Kern, economic advisor to the BCC. "An early cut in interest rates will reduce the need for larger and riskier cuts later on."

Stronger Pricing Pressures On The Manufacturing Sector

The BOE has raised the policy rate five times since August 2006, most recently in July to 5.75%. Most economists tip the central bank's next move in rates to be to the downside, but growing market expectations that a cut could come as soon as November have receded after hawkish-sounding comments from BOE Governor Mervyn King Tuesday. King has expressed concerns about capacity pressures in the U.K. economy, and the BCC survey backed up that view, with the proportion of manufacturing firms running at full capacity rising seven points to a balance of 45%. The balance for services companies gained two points to 42%. In what may pose another headache for the MPC, there were also indications of sharply stronger pricing pressures in the manufacturing sector, the balance for which rose eight points to 32%. "We suspect that the BCC survey will reinforce the Bank of England's concerns that companies' pricing power and capacity constraints still pose a significant inflationary threat," said Howard Archer, chief U.K. economist at Global Insight. Despite financial market turmoil at the time the survey was conducted, services sector business confidence improved in the third quarter, with the turnover confidence balance rising four points to 59%. But the manufacturing sector balance dropped nine points to 52%. When it came to investment, however, the tables were turned. The balance of manufacturing firms planning to boost investment in plants and machinery lifted five points to a record high of 33%, but the balance for service sector firms fell two points to 17% - the lowest reading since the second quarter of last year. The BCC survey polled more than 4,700 companies across the U.K., employing around 300,000 people. It was conducted between Aug. 27 and Sept. 19.