Growth will be stronger than expected, inflation above target and base rates set to rise

Throughout last year I was arguing the recovery would be stronger than expected, inflation would remain above target and interest rates would have to rise much faster than expected. This remains my view for 2011, despite the preliminary estimates for GDP in the final quarter of 2010.

Growth year on year in Q4 as reported was 1.7%. Adjusted for the snow, the figure would have been 2.2% according to the Office for National Statistics. This in itself is a respectable result but below my own estimates of growth of 2.7% in the final quarter of the year.

I expect a strong upward revision of the figure to follow. Consider that growth in manufacturing and construction in Q4 was up by 6% and 7% respectively but business services, transport and distribution were badly hit. Manufacturing and construction have a long history of December lay offs which affect the seasonal adjustment models. The other sectors have no such history in the ARIMA modelling process, hence the initial results will overstate the slow down. It wasn’t so bad after all. The figures will be revised up.

In the first quarter of 2011, growth will be reported above trend. Consider, the latest Markit/CIPS PMI surveys for manufacturing and services. In January the manufacturing index rose to a survey record high, reaching 62 in January from 58.7 in December.

Manufacturing production rose for the twentieth consecutive month in January across all sectors, consumer and capital goods alike. New orders and prospects for employment accelerated to reach levels without precedent in the nineteen year history of survey data.

In the service sector, growth bounced back to an eight month high in January as the index reached 54.5 up from 49.7 in December. The rate of growth of new business registered the strongest gains since April last year as underlying business returned to normal.

So despite the snow, the recovery is on track despite attempts by central government to derail the process with spending cuts, fiscal extraction and the VAT hike.

The focus will now switch from fears of recession, to fears over inflation. I believeThe Bank of England model is fundamentally flawed, with an over dependence on the output gap and a failure to recognise the impact of a lower pound on imported inflation. Commodity prices, especially food and energy prices are under pressure as the BRICs, particularly Brazil, India, China hoover up scarce resources to fuel growth.

Interest rates will end the year higher, the consensus forecast is for rates to reach 1.25% by the end of the year, with increases from September onwards. The lone hawk on the Bank of England Monetary Policy (Andrew Sentance) now has a mate (Martin Weale), together they are both calling for a rate rise. I expect more doves are likely to fly the Governor’s coop, as inflation remains above target and strong growth becomes evident.
If first quarter growth is as strong as I anticipate, rates could begin to rise as early as April or May to around 2.5% by the end of the year.

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