03 Mar 2023
The UK and most other developed economies have been surprisingly resilient this year in the face of record-breaking falls in real incomes and a huge rise in interest rates. The UK economy has been so resilient that we have gone from a large recession being nailed on, to a decent chance that we might avoid one altogether. And even if we do fall into a technical recession, defined as two consecutive quarters of falling GDP, it is likely to be relatively short and mild.
But - before we all pop open the champagne - remember that things have only really improved relative to last year’s forecasts of a serious recession. In absolute terms, even the most optimistic forecasts are expecting zero growth this year, nothing to normally cheer about. In fact, the UK economy will probably be no bigger in 2025 than in 2019 – representing a lost half-decade.
So, what would it take for the UK to not only avoid a recession this year, but to actually post some positive growth numbers?
Of course, there are any number of positive things that could happen. But there are three areas where significant improvements are realistic and would have a major positive impact on the economic outlook:
- Lower energy bills quickly passed through to households and businesses;
- A rebound in labour participation;
- Consumers confident enough to spend their savings.
If the significant fall in wholesale energy prices is quickly passed through to consumers, combined with a return to pre-pandemic levels of inactivity and consumer confidence rebounds by enough that consumers start spending their built-up savings, then our economic forecasts might start with a ‘+’ for the first time in a good long while.
Lower energy bills would lead to lower inflation
Energy prices have already fallen significantly from their December highs as mild winter weather caused a sharp drop in demand. However, this has yet to be passed onto consumers. As it stands, household energy bills are due to rise by 20% in April, and businesses face an energy-cost cliff in April when the introduction of a weaker government support package will cause a jump in bills.
Ofgem recently announced that the energy price cap would fall to £3,280 in April, from the £4,279 it is currently. Of course, consumers haven’t been paying that much. The Government’s Energy Price Guarantee (EPG) limited the typical bill to £2,500. But the EPG is set to rise to £3,000 in April, not far off Ofgems price cap. Note too that the £67 a month grant that all households are currently receiving towards their energy bills will stop at the end of March. Accordingly, rising energy bills will reduce the amount of money that the average household has to spend on other goods and services by 2.3%.
As things stand the typical household's annualised bill will likely decline to about £2.2K in Q3 and stay at about that level in Q4, if future prices hold steady. At the end of last year, the average bill looked set to remain at £3.0K until Q3 2024. That will knock off about 2 percentage points (ppt) from inflation in the second half of this year.
But there is clearly scope for the Government to take action to lower energy bills further. The Government could keep the EPG at £2,500, given the EPG’s overall cost has amounted to about £30bn less than anticipated. This would probably cost around £2.5bn so if there are any goodies in the upcoming Spring Budget, this is likely to be it.
Getting inflation back to the 2% target is a precondition for the economy to start growing again. Lower energy bills would reduce inflation directly through lower household bills but would also reduce the need for businesses to increase prices, further reducing core inflation and the need for further interest rate rises.
More people working = faster growth
Aside from the huge rise in energy prices, the main issue holding back the UK economy has been labour shortages. There are currently around 280,000 fewer people working in the UK than before the pandemic, that’s about 1% of the total UK workforce.
According to ONS data most of the people who have become inactive, defined as not looking for a job, say they are no longer looking for work due to illness.
This has had two negative effects.
The first, and most obvious, is that fewer people producing goods and services means a smaller economy.
The second is that the reduction in the active workforce has increased competition for the remaining workers, driving up wage growth and, in turn, inflation. This is one of the key reasons why the Bank of England has been raising interest rates and why it might have to go further.
There are some positive signs though. In December there was a 113,000 drop in the number of inactive people driven by both declines in early retirement and long-term sickness of 50K and 54K, respectively.
Getting more inactive people back into the workforce would have two positive effects. It would directly boost growth as firms could increase output. Admittedly, not everyone who went from being inactive to looking for employment would immediately find it, so even if inactivity levels returned to their pre-pandemic rates the boost to the economy would be smaller than 1%. But, the rise in the unemployment rate would reduce pressure on employers to raise wages (and eventually prices), and, critically, it would reduce the pressure on the Bank of England to raise interest rates by even more.
Low consumer confidence holding back spending
Coming into the cost-of-living crisis household’s balance sheets were in robust shape. They had used the pandemic to pay down debt and build up a pot of savings worth almost £200bn. In theory, households could use these savings to insulate themselves from the worst of the spike in inflation and prevent an economic contraction. However, instead of spending their savings, households have spent most of the last year continuing to add to them at an elevated rate, compounding the drop in real incomes.
This is because consumer confidence has also fallen to rock bottom. Consumers that are worried about the economic outlook, their jobs and their ability to pay their bills in the future won’t want to reduce their savings pot. Contrast this to the US, where consumers have spent about half the excess savings built up in the pandemic and its obvious why the US economy has outperformed the UK by such a wide margin.
But here there are signs of good news as well. Consumer confidence has rebounded significantly since its low in September, although it is still well below its historic average. What’s more, the increase in consumer credit to £1.6bn in January, the highest borrowing since June 2022, combined with another relatively low increase in household savings suggests that consumers are becoming more willing to start spending again.
Of course, the danger would be that a surge in consumer spending would just push up inflation again, requiring action from the Bank of England. But, if improved consumer confidence was combined with a rebound in the labour participation rate and lower headline inflation due to falling energy prices, then the additional spending may result in a boost to the real economy rather than inflation.
To be clear, our base case is that the UK will enter a short mild recession in the first half of this year. But that is no longer a guaranteed thing. If inflation falls more quickly than anticipated, the supply of labour rebounds or consumers find their animal spirits then economics may once again have found itself to be the dismal science.