Britain: Weak Factories, Strong Services: A Rate Dilemma

Britain's two-track economy is posing a dilemma for the Bank of England. Should it ease because the manufacturing sector is in a recession? Or should it tighten out of fear that a vibrant service sector will generate inflation? For now, the Monetary Policy Committee (MPC) seems content to do nothing, as it waits to see which force will dominate the economy.

Weak foreign demand and a strong British pound, which makes exports costlier abroad, are pummeling factory orders and output. Industrial production in May plunged 0.9% from April, led by weakness in tech equipment. The 1.9% yearly decline was the worst since 1992. The May drop assures a third consecutive quarterly decline in output, especially given the June weakness in the purchasing managers' survey of manufacturers.

Weak global demand and profits are also hammering business investment. Based on recently revised data on gross domestic product, capital formation posted the largest drop in seven years. Manufacturers' profits are suffering from a lack of pricing power not only abroad, but from attractively priced imports at home. In June, the prices of goods leaving the factory gate rose 0.4% from a year ago, the smallest annual rise in more than four years.

But manufacturing is only one-fourth of British GDP. Upbeat consumers, powered by the tightest labor market in 25 years and this year's three quarter-point cuts in interest rates, continue to power domestic demand for a wide range of services and new housing, keeping upward pressure on overall prices. Underlying inflation, which excludes mortgage interest, jumped to 2.4% in May, threatening to exceed the MPC's 2.5% target. Retail sales volumes in May grew at the fastest yearly rate in almost four years, and in June a key measure of consumer confidence rose sharply.

So what's the MPC's next move? Economists think continued erosion in global conditions might allow one more quarter-point cut in the base lending rate, to 5%, by yearend, but later in the second half rather than sooner.

By James C. Cooper & Kathleen Madigan

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