28 November 2023
We’re anticipating growth of just 0.5% in 2024, meaning the UK is set to endure yet another year of stagnation. The good news is that inflation is likely to fall to 2.5% by the second half of next year. As a result, interest rates have almost certainly peaked at 5.25% and are likely to fall in the second half of the year, ending 2024 at 4.5%.
The main tailwind for the economy next year will be the rebound in real wages, driven by a sharp drop in inflation and robust wage growth. Indeed, we expect inflation to average about 2.7% in 2024, while wage growth will only slow to around 4.8%. Combined with a recovery in consumer confidence, this should support a modest rise in consumer spending.
However, this increase in income will be offset by two headwinds. The first is the continued impact of the previous increase in interest rates. Approximately 1.6 million households will remortgage in 2024 and face a substantial hit to their incomes. Second, fiscal policy is set to significantly contract as cost-of-living support is phased out.
On balance, we are expecting growth of about 0.1% a quarter for most of next year. While that would be enough to keep the UK economy out of recession, it would only take the smallest increase in headwinds to tip the UK into one. It will probably be 2025 before the economy gets back to any significant increase in growth.
There are two main factors holding the economy back. First, the number of people employed in the UK is still below its pre-pandemic level, despite the population increasing by almost 300,000. This compares unfavourably to the euro-zone where employment is almost 3% above its pre-pandemic level and the US where its about 1.5% above. This trend is likely to continue next year. Without the government managing to entice more people back into work, achieving significant growth will be difficult.
Second, the maligned state of business investment in the UK and productivity growth has been well documented. Productivity in the UK grew by just 0.3% year on year (y/y) in Q2 compared to growth of 2.2% y/y in the US. Given that we expect labour supply to remain muted amid high levels of sickness and difficult demographics, an increase in productivity will be crucial to breaking the economy out of its growth funk. Solving these two issues are the major themes that all political parties should be thinking about ahead of the next general election, likely to happen towards the end of next year.
- Labour market
- Interest rates
- Disposable income and spending
- Recession/economic outlook
On the right track but a way to go yet
One ray of sunshine for Rishi Sunak is that he is likely to meet his promise to halve inflation by the end of the year. When the Prime Minister made that pledge inflation was running at 10.6%, so it needs to fall to 5.3% by the end of the year. We think it will end the year between 4.5% and 5%, meaning that’s one thing he can tick off his list. Thereafter, we think inflation will fall to around 2.5% by the second half of next year, where it will probably hover for the rest of 2024.
Inflation fell to 4.6% in October as the big increase in energy prices last year was replaced by a small fall this year. Energy prices will continue to be the driver of falling inflation over the next year as lower wholesale prices are gradually reflected in Ofgem’s energy price cap. What’s more, food price inflation peaked in March and will continue to trend down over the rest of the year. Indeed, we expect the contribution of food to headline inflation will fall from 1.2 percentage (ppts) in October to just 0.2 ppts by May next year.
In addition, core goods inflation should continue to fall as lower commodity and wholesale prices make their way through the supply chain. Producer output price inflation was -2% in October suggesting there is plenty of room for core goods inflation to fall further.
These factors will drag goods inflation down from about 3% in October to 0 by the middle of next year, that will knock a full percentage point off headline inflation.
Of course, there are some obvious risks. Natural gas prices are up by about 15% in response to geopolitical risks. If energy prices were to rise by substantially more, then inflation would fall much more slowly or may even rise again.
The stickier part of inflation will be the services basket. The good news is that lower energy prices will feed through into lower inflation as firms no longer have to pass on that cost. Similarly, the stabilisation in car prices and construction costs will feed through into lower insurance inflation from Octobers whopping 21.3% rate.
The crucial metric for services business, though, is labour costs. Wage growth currently running at almost 8% annually, which is far too high for inflation to fall back to 2% on a sustainable basis. To put that into context, the Bank of England estimates that wage growth needs to fall to around 3.5% for headline inflation to drop back to 2%.
As it happens, we do expect wage growth to slow over the next year as the labour market continues to loosen (see next section), which will allow services inflation to gradually fall back as well. We expect services inflation is likely to fall from around 7% now to 4% by the middle of next year.
Tight but loosening
The recent easing in the labour market is likely to continue next year with the unemployment rate set to reach 5% by the end of 2024. This will eventually translate into slowing wage growth. Admittedly, there are now significant questions around the accuracy of the labour market data. Nonetheless, we think there will be enough evidence to show that the labour market is easing to dissuade the Monetary Policy Committee (MPC) from raising interest rates any further.
The labour market has turned a corner recently. The unemployment rate has risen to 4.2% from 3.7% at the start of the year and vacancy numbers have dropped below one million for the first time since January 2021. That said, the labour market is still tight by historical standards, especially for a time of prolonged economic weakness.
Admittedly, the changes to the labour market data will cloud the picture. The recent sharp fall in the response rate to the Labour Force Survey has compelled the ONS to switch to alternative means of estimating employment and unemployment by using tax and claimant count data. These experimental estimates will serve as a stopgap until the spring when the ONS will relaunch its official employment data.
However, we expect the big picture to remain the same, despite the changes in data collection. Hiring slowed sharply recently as the weak economic picture deteriorated further. Given we expect economic growth to remain subdued at best over the next year, hiring is likely to remain low. At the same time, labour supply should continue to improve as the impact of the cost-of-living crisis and increasing real wages tempt more people back into the labour force.
Overall, we expect the unemployment rate to gradually rise from 4.2% currently to 5% by the end of 2024.
The loosening in the labour market has so far not been reflected in a significant reduction in wage growth, but this is probably just a matter of time. As the labour market continues to loosen we expect wage growth to slow from around 8.1% currently to about 3% by the end of next year. But pay growth should remain above inflation for the whole of next year, meaning that real wages will grow, which will help to support consumption and prevent the UK falling into recession.
Strolling along the top of Table Mountain
Sharp falls in inflation and slowing wage growth over the next year means interest rates have probably already peaked at 5.25%. Attention will now start to turn to when interest rates will be cut, which we don’t think will be until Q3 2024. Even then cuts will be gradual, we expect interest rates to finish the year at 4.5% and eventually settle at around 3.5%.
The Monetary Policy Committee (MPC) has made it clear that interest rates are now in restrictive territory. Indeed, the MPC has that they will have to stay at current levels for 'sufficiently long' to have the dampening effect on the economy and inflation that the MPC is looking for – the “Table Mountain” approach.
Recall that the Bank of England’s Chief Economist, Huw Pill, made an analogy between different types of mountains and interest rate policy. In the ‘Matterhorn’ (the famous Toblerone mountain) approach, interest rates continue to rise steeply, bringing inflation under control more quickly but also probably igniting a recession, which would allow the central bank to cut interest rates rapidly. The ‘Table Mountain’ (the flat-topped mountain in Cape town) approach suggests that interest rates don’t rise much further, but stay at their peak for longer. This creates a slower but more manageable drag on inflation and the economy. It seems the Table Mountain approach has won out.
So, the key question is how long is 'sufficiently long'? Our economic forecasts suggest that it will be around Q3 next year before the MPC feels comfortable enough to start cutting interest rates again.
This is because the changing structure of the mortgage market, with more people having fully paid off their loans and most others having longer term loans, means that interest rates need to stay higher for longer to have the same impact on inflation.
What’s more, the labour market is now structurally tighter than before, due to the vast increase in sickness, which means wage growth and services inflation will only fall gradually.
Finally, the MPC has come in for a lot of criticism, some deserved some not, for letting inflation get out of control over the last year. It will probably err on the side of keeping rates high for too long rather than cutting too soon.
The most likely reason that interest rates come sooner is because the economy has fallen into a recession that pushes up the unemployment rate and brings wage growth and inflation down more rapidly than expected. The nightmare scenario for the MPC is another surge in energy prices that pushes up inflation again and weakens the economy.
Disposable income and spending
A rare bright spot
Rising real wages over the next year will be the primary driver of improving real household disposable incomes. However, higher interest costs will offset the increase in incomes for many households and other households will look to rebuild their savings buffers. As a result, while consumer spending should rise next year, we aren’t expecting a strong recovery until 2025.
Average weekly wages look set to rise more quickly than consumer prices over the next year as goods prices stabilise and energy bills decline. Indeed, the National Living Wage looks set to rise by about 7% next April, while the Real Living Wage has just been increased by 10%.
Admittedly, higher interest rates will counteract some of this increase in incomes. Indeed, the typical homeowner mortgaging will face a whopping hit of about 7% of their disposable income. But given that only 7% of fixed rate mortgages are refinanced each quarter, the effective rate on the stock of mortgages is increasing by less than 0.1% per month. So, mortgage refinancing looks set to deliver only a 0.2 percentage point hit again to real incomes in aggregate per quarter, which will be a drag on real incomes but shouldn’t prevent them rising.
So, household real disposable incomes should rise consistently over the next year. But how much of this increase actually gets spent, largely depends on how consumer confidence evolves.
Confidence has improved significantly over the last year, but it is still well below the levels we would normally consider consistent with growing spending. Indeed, this is probably one reason why retail spending has been so subdued recently. Confidence should improve as inflation falls and real incomes continue to rise, but the sharp drop in confidence in October highlights how fragile any recovery is.
What’s more, there are a significant portion of households which will need to rebuild their savings buffer after the cost-of-living crisis. In real terms, households’ liquid assets are almost back to their 2019 level but below the level implied by the gently rising pre-coronavirus trend. In addition, the savings intentions balance of GfK’s consumer confidence survey—which remained above its long-run average in October, despite edging down from September— implies households will continue to save more over the coming months.
As a result, real consumer spending will probably only rise by a subdued 0.7% next year.
Sitting on the seesaw
The UK should avoid a recession by the skin of its teeth, but another year of stagnation looks likely as the impact of rising household incomes are offset by the growing burden of previous interest rate rises and tighter fiscal policy.
The UK economy will resemble a seesaw over the next year. On one end will be the recovery in households’ real incomes, driven by falling inflation and a robust labour market. On the other side will be the impact of the huge surge in interest rates that have happened over the last year and a half on households and businesses. These two factors will largely offset each other in 2024, meaning that growth is set to stagnate again. We are expecting growth of fractionally above 0 in 2024. While that would mean the UK avoids a recession by the skin of its teeth, it would take only a small further deterioration in the outlook for the UK to fall into a recession. It will be 2025 before the economy regains any real momentum.
There are three obvious risks on the horizon that could alter this outlook.
First, a sharp and sustained increase in energy prices would push inflation back up across the developed world, which would result in another cost-of-living crisis and a sharp contraction in growth. In addition, central banks would probably be forced to raise interest rates again, further deepening any recession.
Second, consumer confidence is fragile. A recovery in confidence looks likely as real wages increase and the unemployment rate only drifts up. However, if there is a retrenchment in confidence, the already muted recovery in consumer spending that we expect could fail to appear.
Third, while any general election will probably come too late to make a difference to the economic outlook next year, any significant changes at the Spring Budget could have an impact.