The squeeze on household real incomes will intensify as rising interest rates join soaring inflation. Admittedly, the Government’s austerity measures won’t harm growth in the short term, most of the pain has been delayed until after the next General Election. But, they won’t help the economy much in the short term either. However, not all recessions are created equal. We expect a peak-to-trough fall in GDP of around 2.5%. That would be slightly smaller than the early 1990s recession and significantly less than the Global Financial Crisis.
We expect the unemployment rate to rise from the 3.6% it is now, to around 5% by the end of 2023, entailing job losses of about 200,000. Hospitality and retail sectors are likely to bear the greatest losses as consumers discretionary spending power shrinks.
Looking for the good news? Inflation will fall over 2023. The bad news is that it will probably still average around 7.5% over the whole of next year. High inflation and a tight labour market will force the Bank of England to raise interest rates from 3% currently to around 4.5% early next year. It will be 2024 before the bank considers cutting rates.
Recession impact: an ongoing squeeze in real incomes, lowering consumer spending
Households’ disposable incomes have been hammered by the cost-of-living crisis, which has seen inflation soar from 0.5% at the start of 2021 to 10.1% in September 2022 due to the huge rises in food and energy prices. The Government’s energy price guarantee (EPG) has shielded households and businesses from the worst of the energy crisis. But, utility prices will rise by another 20% in April 2023 when the government’s Energy Price Guarantee for the average annual utility bill rises from £2,500 to £3,000.
As if that wasn’t enough, the surge in mortgage rates will further sap households’ disposable incomes. Mortgage rates have surged well ahead of the base rate as banks anticipate higher interest rates, meaning that anyone unlucky enough to be mortgaging over the next few months will see the share of their income spent on the soaring mortgage interest. For example, the average borrower rolling over a 75% LTV ratio two-year fixed rate mortgage today for another two years will see the proportion of their incomes being absorbed by monthly repayments soar to about 34%, from 22%.
What’s more, a loosening labour market, as firms reduce hiring and even start to cut workforce numbers, will result in nominal wage growth dropping back to more ‘normal’ levels. Throw in higher taxes potentially worth 1% of GDP and a real terms reduction in public sector pay, and the 2023 outlook is bleak for household’s real disposable income (RHDI).
All in, we are expecting RHDI to contract by 2.5% in 2023. That would be the biggest fall on record.
Admittedly, consumers have, on average, a considerable level of savings, equivalent to around 10% of GDP. But given consumer confidence is at a record low, we aren’t expecting them to dip into these savings by much. In fact, the latest data suggests consumers are adding to their savings pile rather than dipping into it.
So, consumers have less money to spend and are less willing to spend it. This will inevitably mean a sharp reduction in consumer spending, especially on discretionary items such as hospitality and retail goods. We are expecting a decline of 2.0% in total consumer spending next year.
Surging interest rates and slumping demand will also reduce business investment and it looks like the upcoming budget will significantly curtail government investment.
Business investment is still about 8% below its previous level, mainly driven by a slump in investment in offices and transport equipment, as demand for office space and travel has not fully recovered because many people have continued to work remotely.
Inflation: Slowing but still elevated
The recession will go some way to reducing domestic inflationary pressures. Some leading indicators are already pointing to an easing in domestic price pressures. With energy price inflation about to turn down decisively, UK CPI inflation will soon start to fall from October’s 41-year high of 11.1%. In addition to that, the current $80 level of Brent crude oil prices suggests that motor fuel's contribution to the headline rate will fall to almost zero by March. The stabilisation of food prices over the last six months also points to food CPI inflation falling quickly next year. Meanwhile, the plunge in shipping costs and increase in retailers' stock levels suggests that core goods prices will fall back soon.
Even so, inflation will remain high for most of next year. We think that inflation will be around 7.0% in mid-2023, around 4.0% by the end of 2023, but may fall below the Bank of England’s 2.0% target in the second half of 2024.
However, there is a risk that inflation proves stickier than we think, either because a tight labour market means that wage growth falls more slowly than we expect or because firms are rebuilding margins. Indeed, the Q4 edition of the RSM UK MMBI showed that Middle market firms getting better at passing on costs. That said, the recession and weaker demand will make it more difficult for middle market firms to continue to pass on higher costs. With inflation set to remain high throughout 2023, it will be difficult for firms to continue to defend their margins.
Labour market will loosen, but not by much
The recession will inevitably cause unemployment to rise. Slumping demand reduces the need for staff, but this is combined with the huge squeeze in firm’s costs and rising interest rates, forcing firms to shed staff.
However, we do not expect unemployment to surge, especially in sectors experiencing a skills shortage. The labour market is incredibly tight because of a lack of supply of labour, not because of an excess demand for workers. And, given the recent challenges firms have had in recruiting staff and the relatively short recession, firms will have more of an incentive to hoard labour than in previous periods of economic weakness. The exceptionally tight labour market probably explains why, in this quarters MMBI, 41% of firms said they hired more staff in Q4, despite the dire economic outlook.
Ultimately, we expect the level of vacancies to fall from near-record levels to below 1 million and the unemployment rate to rise to a peak of 5% by the end of next year, significantly lower than the 8.5% peak reached in the aftermath of the Global Financial Crisis. If that were all to come from employed workers becoming unemployed it would mean a loss of about 400,000 jobs. But we expect some people who are currently inactive (ie they’re not currently looking for work) to come back into the workforce as they seek to boost their incomes. This will probably raise the labour market participation rate and mean total job losses could be closer to 200,000.
Policy considerations: Austerity delayed, but interest rates risingThe £55bn (1.8% of GDP) package of austerity measures focussed to start in fiscal year 2027/28 and announced in the Autumn Statement was the largest tightening in policy since Osbornes’ infamous “austerity” budget in 2010. But by delaying all of the pain until after the next general election, the Chancellor’s austerity measures won’t harm growth in the short term.
That said, the big contractions in spending scheduled in from 2025 could depress the recovery.
With the labour market still tight and inflation still high, we think the central bank will continue to push rates higher in the near term with a 50-bases point (bps) hike in December followed by a 50-bps move in February and two 25-bps rises in March and May, taking the policy rate to a peak of 4.50% by June 2023 from 3% in November 2022.
Even with the economy in the midst of a recession, we doubt the Monetary Policy Committee (MPC) will be comfortable cutting rates until it’s clear that core inflation is falling sharply towards the 2% target. In our forecasts, that doesn’t happen until early 2024. We have assumed cuts of 25 bps-a-quarter from that point until the end of 2025.
In the near term we think the risks are tilted toward high inflation proving persistent, either because of wage growth remaining high or firms rebuilding margins. However, beyond the next 12 months, the risks are tilted toward rates falling faster than we have pencilled in, as headline inflation drops back and the labour market loosens. That will give the MPC space to shift its focus back to supporting the economy.