You do not need me to tell you that the latest surge in energy prices is bad news for the UK economy. Over the past two months, natural gas prices have almost doubled, while oil and wholesale electricity prices have risen by around 50%. If those increases persist, utility bills could rise by a further 25% in January. The impact will not stop there. Higher energy costs are feeding through to a wide range of commodities, with wheat prices up around 50% year on year and copper reaching record highs on strong demand from the global push towards electrification. The result is a fresh inflation shock that threatens to squeeze households, weigh on businesses and complicate the outlook for policymakers.

Inflation now looks likely to rise to around 4.5% early next year, and the consequences are unlikely to be positive.

How rising energy prices are creating a new inflation shock for the UK economy

Higher energy prices act like a tax on UK companies and households that suck demand away from other parts of the economy. Every pound that is spent on imported oil and gas is a pound that’s not spent on goods and services elsewhere. That will hit the economy hard as we move into winter and energy consumption rises. The roughly one percentage point increase in peak inflation as a result of the recent jump in energy prices will probably knock about 0.5ppts off economic growth over the next few quarters. The easiest way to visualise the impact is in real wages, which is your pay packet adjusted for inflation. Average wage growth was 3.7% y/y in July and for the private sector was just 2.8%, so assuming there is no big pick up in wage growth, inflation of 4.5% means real wage growth will turn negative early next year. That will limit consumers ability to spend.

How higher inflation could put further pressure on public finances

Inflation above 4% is probably too high for the Bank of England to ignore. As a result, the likelihood of an interest-rate rise in November has increased sharply and now appears greater than 50%. If energy prices remain close to current levels, a second increase in February could follow. The minutes from last week’s Bank of England meeting suggest policymakers are more concerned about inflation than they were earlier in the summer. Governor Bailey set the tone by noting that, if the Middle East conflict persists, policy may need to tighten further. There are still good reasons for caution, particularly the weakness of the labour market, but the balance of risks has shifted towards higher rates. That would add to the pressure on households already facing higher bills for fuel, utilities and borrowing costs.

Can the UK economy remain resilient through a difficult winter?

Higher inflation, rising debt-interest costs and the prospect of another cost-of-living squeeze will make an already difficult fiscal position even more challenging. Commitments not to raise the three largest taxes, combined with adherence to the fiscal rules and a higher cost of borrowing, leave little room for a large-scale energy support package. That increases the likelihood that the government will either seek additional revenue through economically damaging tax measures or rely on temporary borrowing that could place further upward pressure on the UK’s borrowing costs.

The key question is no longer whether higher energy prices will affect the economy, but how much damage they will do. So far, businesses and households have shown remarkable resilience. However, with inflation rising, interest rates likely to move higher and fiscal policy constrained, the economy faces a more difficult winter than many expected just a few months ago. The coming weeks will provide an important test of whether that resilience can continue to hold.

Britain’s productivity problem may not be quite as bad as we thought.

New estimates from the ONS suggest productivity growth since the financial crisis has been significantly stronger than previously estimated. Between 2009 and 2019, output per hour grew by an average of 1.3% a year, rather than the 0.7% previously estimated. That cuts the apparent size of the post-financial-crisis productivity slowdown almost in half.

The reason is not that Britain has suddenly become richer. Instead, the ONS has improved how it measures the number of hours people actually work. The new approach takes better account of holidays, sickness, bank holidays, overtime and other factors, using a wider range of survey, business and administrative data.

So, we produced the same amount as we thought, we just did it by working fewer hours. That might sound like a statistical footnote. It isn't.

Productivity is ultimately about how much an economy produces for every hour worked. Higher productivity means more scope for higher wages, living standards and economic growth without generating the same inflationary pressures.

The new data therefore offer a more encouraging interpretation of Britain's economic performance. The productivity puzzle hasn't disappeared, and growth remains well below its pre-financial-crisis pace. But the gap is smaller than we thought.

This week’s survey data will give us the first insight into how the economy has fared through September.

We expect the PMIs to show a slightly slower pace of growth in September after a strong August with the Composite PMI easing from 52.5 to 51.8, consistent with a modest pace of growth into the Autumn. Averaging that with the July and August PMI points to growth between 0.1-0.4% in Q3, suggesting the risks are skewed to the downside of our forecast for 0.4% in Q3.

However, the PMIs tend to overreact when uncertainty is high. For example, growth averaged 0.5% per quarter in the first half of the year, compared to the 0.2% per quarter steer from the PMI so we think the economy will continue to beat expectations through Q3.

Elsewhere, we think consumer confidence will ease back from -14 to -16. Inflation likely accelerated further in September, turning private sector regular pay growth negative and weighing on consumer confidence.

All told, we think the first glimpse of survey data for September will show that the UK economy continues to weather higher energy prices reasonably well, but beyond Q3, growth is likely to slow as inflation rises over 4% dragging on real incomes and the Budget adds to uncertainty in October.

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