British Manufacturing PMI Falls Badly - BoE Still Doesn't Lower Interest Rates, Rightly

by: Tim Worstall
Summary

U.K. Manufacturing PMI has dropped precipitately - a market of a possible recession.

Yet the Bank of England didn't lower interest rates, the traditional solution. Brexit is already taking care of the problem.

Traditional economic analysis just isn't going to be much use for the U.K. until after October 31.

Our Basic Problem Here

Manufacturing PMI is only really an example of the point to be made about the British economy. An exemplar if you like. If we have manufacturing production falling strongly - as the PMI indicates - then we'd usually expect some policy response. Perhaps an easing of interest rates say.

But we've also just had the Bank of England monetary policy notes and they're not thinking about such in the slightest. Why?

In this instance because the other possible traditional response is to try and get the pound's FX rate lower. This boosts manufacturing exports. But worries over Brexit have already done this for us. As I say, this is only an example of the larger point.

Little traditional macroeconomic analysis is going to be of great use concerning the UK economy over the next few months. Because Brexit is the over-riding event. Everything else, other than a full scale depression, pales into insignificance against that coming event. Thus we shouldn't expect the traditional responses to whatever macroeconomic events come our way.

Manufacturing PMI

As we all know by now a purchasing manager index is based upon a pretty simple idea. Whatever is going to be made next month has to be put together out of what people have ordered this month. Well, not exactly, but the basic idea stands. So, if we ask the purchasing managers what they ordered this month then we've a cute idea of what production will be next.

Mash the responses up into an index, so that 50 is break even - more than 50 means expansion, less contraction - and we've got a leading indicator of what the near future holds. It's not perfect but it's about the best such leading indicator we've got of GDP for four to eight weeks in the future.

The reading for the UK today is bad:

UK manufacturers reported the largest monthly fall in production for seven years in July, with recent order book weakness also leading to one of the largest culls in factory employment for over six years. Price pressures meanwhile eased, despite the weakened exchange rate, as more suppliers offered discounts in the face of disappointing sales levels.

Production slumps

At 48.0 in July (unchanged on June) the IHS Markit/CIPS UK Manufacturing PMI® indicated a third successive monthly deterioration of business conditions, with the rate of decline continuing to run at the steepest since February 2013.

Output fell in July to an extent not seen since July 2012, and a rate exceeded only twice1 since the height of the global financial crisis in early-2009. At its current level, the output index is consistent with the official measure of manufacturing production falling at a quarterly rate of 1%, or 4% annually.

This is the sort of fall we associate with the onset of a recession - sure, here only in manufacturing but still.

In graphic form:

UK PM I (UK Manufacturing PMI from IHS Markit)

As you can see in your mind's eye that doesn't correlate perfectly with recessions - we didn't have one in 2016 for example - but it is closely associated. For we came close to recession in 2016 and 2012.

So, We'd Expect Action, Right?

We would expect action at this point. The most likely and traditional one being to lower interest rates at this point. That would gee up the economy nicely and given that manufacturing is always more volatile than the economy as a whole that would solve this problem. Yet has the Bank of England done so? Nope, quite the opposite:

It was no surprise that the Bank of England’s Monetary Policy Committee unanimously voted to leave interest rates unchanged at 0.75% in August. The meeting’s minutes were nonetheless less dovish than expected—the bank now expects excess capacity to build up to 1.75% of potential GDP by mid-2022, which would still warrant interest rate increases

They're actually thinking about increasing interest rates. Entirely contrary to the traditional expectations from such a PMI reading, So, what's going on?

It's All Brexit

One reading is that we had a bolus of manufacturing activity earlier in the year as people stockpiled over the March 29 supposed date of Brexit. As ever with any form of stockpiling this is just bringing forward future economic activity. The date passed - Brexit didn't happen sadly - and so we all know that the stockpiling will unwind. So, we know/knew that manufacturing output would be a little weak in this period.

That in itself being a little story of the larger contention here. It's Brexit that matters to the UK economy at present. No information nor policy response to such is going to make sense without considering that issue.

Another reading is that a major effect of lowering UK interest rates is to lower the FX rate of the pound. But then Brexit itself is already doing that. As I've said before:

That major determinant of sterling's value is exactly as predicted - predictions and assumptions about the whether and the form of Brexit. The more likely it is to happen, the "harder" it is if it does, the lower sterling becomes.

Boris Johnson has just become PM. That makes Brexit itself more likely to happen, makes a harder version of it more likely too. So, the pound has fallen. Thus what need for lower interest rates if we've already just helped manufacturing exports via a lower pound?

My View

Which is what I mean about Brexit being important. In real terms I don't think it is going to be all that important but then my prejudice on this subject is well known - I used to work for Nigel Farage. But we're simply not going to understand either events nor policy responses to them in the UK for the next few months unless we take the Brexit issue into account.

This makes all our usual calculations about macroeconomic statistics a little awry.

The Investor View

Quite simply, any decision or idea you've got about the UK economy must be measured against Brexit. The pound - and thus the stock market indices - will be bouncing around according to the likelihood of a hard Brexit. Near nothing else will matter for these two valuations.

Thus any decision or idea you have concerning the UK hasn't been properly thought through until you've considered the Brexit angle. Once it's all happened then we'll be back to normal but not until then.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.