08 August 2023
No one would have asked for the kind of pressure that the UK economy has been under for the last three and a half years. But the economic environment doesn’t look nearly as bad as in 1981 (the year Queen’s ‘Under Pressure’ was released for the information of our younger readers). That said, at best the UK is likely to continue to muddle through with high inflation and extremely low growth. It would take only the smallest increase in headwinds to blow the economy into a recession in the next 12 months.
The outlook for economic growth over the next year remains muted. On the positive side, inflation should fall sharply, which combined with a relatively resilient labour market, means that households real incomes should start to rise again.
However, we have probably only seen about half the impact of the previous surge in rate hikes be truly felt in the real economy. As such, there is a significant hit to the economy to come over the next twelve months and all the latest data is pointing to the economy losing momentum in the second half of the year.
The ultimate decider of whether the economy slips into recession or not will be how high and how quickly interest rates ultimately go. Admittedly, the recent fall in interest rate expectations increases the chances that the UK achieves a “soft landing”, where inflation falls back to the 2% target without a recession. And if interest rates do peak at 5.5% or 5.75% then the UK may avoid a recession by the skin of its teeth. But if interest rates rise to the 6.5% level that financial markets were pricing in only a few weeks ago, a recession looks almost guaranteed.
Those would really be the days when it never rains but pours.
|GDP (Q/Q %)||0.0||0.1||0.1||0.0||0.2||0.2||0.4||0.3||0.5|
|Consumer Spending (Q/Q %)||0.0||0.1||0.0||0.0||0.2||0.3||0.3||0.2||0.5|
|CPI Inflation (Y/Y %)
|Core Inflation (Y/Y %)
|Unemployment Rate (%)
|Average Weekly Wages ex bonuses (3m Avg., Y/Y %)
The Stagflation Nation
There is a good chance that the UK slips into recession early next year. But even if it does, that recession is likely to be short and mild. The bigger picture is that the outlook over the next twelve months looks much the same as the previous twelve, namely high inflation and virtually non-existent growth. We expect growth of just 0.3% in 2023 and 0.5% in 2024, meaning the economy will be virtually the same size in 2024 as it was in 2019 – marking five years of no growth. The UK is well deserving of the title of ‘Stagflation Nation’.
On the plus side, the anticipated drop in inflation, combined with relatively strong wage growth means that households real disposable incomes should start to rise again from the start of next year.
However, we don’t think that will trigger a spending boom for three key reasons.
First, consumer confidence is still around the same levels it fell to during the pandemic. Consumers are still too concerned with their financial situations to go on a spending spree with any additional income they receive.
Second, many households have run down their savings during the cost-of-living crisis. Indeed, in real terms savings are below their trend level, so any additional income is likely to be used to rebuild savings buffers rather than be spent.
Third, the huge rise in interest rates will mean that for many households any additional income will be more than offset by higher mortgage and rent payments. And even for those households not immediately re-mortgaging, there is convincing evidence that they are pre-emptively paying down debt ahead of a future re-mortgage. What’s more, higher interest rates also provide an incentive for households to save any additional income rather than spend it.
So, we doubt there is going to be a boom in consumer spending even as household incomes improve.
But there is also growing evidence that the rise in interest rates is having an impact on the corporate sector. Almost 80% of corporate bank loans are floating rate, so the effective interest rate on the stock has soared to 5.89% in May, from 2.75% at the end of 2021. The blow to corporate profits from the rise in borrowing costs looks set to be even larger than in the early 1990s, when firms slashed employment and capex.
Output in the construction and housing sectors looks most vulnerable to rising interest rates and we expect business and residential investment to be hit hard.
Finally, the huge increase in the government’s debt interest costs will prevent any pre-election give aways. That means the fiscal tightening pencilled in for 2024/25 will continue more or less as planned, representing another headwind for the economy.
All this means that we think the economy will average zero growth over the next four quarters. 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.
Inflation has turned a corner
After seeming to defy gravity for the first half of this year, inflation has fallen sharply over the last month, from 8.7% in May to 7.9% in June. This is mainly due to base effects, as the previous very sharp rises in energy, shipping and commodity prices start to fall out of the annual comparison. But the most recent falls in inflation have been broad based and near-term inflation momentum has fallen sharply. Indeed, monthly annualised inflation fell to just 1.3% in June, a clear sign that price pressures are easing.
More importantly, inflation looks set to continue to fall sharply over the next year or so as falls in energy and commodity prices continue to feed through to headline inflation. For example, energy price inflation is likely to go from adding 1.3 percentage points (ppts) to inflation in June to subtracting about 1 ppt from inflation by October. What’s more, producer output prices now are falling; core output prices dropped by 0.3% June—the first decline since September 2020 - pointing to considerable scope for core goods CPI inflation to fall further.
Admittedly, services inflation, which is much more related to the domestic economy and the labour market, will prove much stickier than goods inflation. But most forward-looking indicators are also pointing to services inflation falling as well, and signs of emerging slack in the labour market will help to constrain wage growth.
Overall, headline inflation is likely to fall to between 4% and 5% by the end of the year and drop to the 2% target in the second half of next year.
Interest rates – in sight of the peak
The recent slowing of inflation means that financial markets are now expecting interest rates to peak at around 5.75%. That level feels about right.
Wage growth of 7.2% is far too high for the Monetary Policy Committee (MPC) to stop hiking rates. To put that into context, the Bank thinks that wage growth of around 3% is consistent with 2% inflation. Given that wage growth is a big determinant of services inflation, we doubt that the Bank will feel confident enough to pause its hiking cycle until it sees convincing evidence that wage growth is slowing sharply and sustainably. That probably won’t happen until the end of the year and will probably require another step down in economic growth.
That means there are probably at least another 50 basis points (bps) of hikes to come and possibly another 75 bps. That would take interest rates to a peak of 5.75%.
The risk is that interest rates go higher. The reduction in the proportion of households with a mortgage and rise in household savings means the impact of higher interest rates on households’ incomes is smaller than in previous hiking cycles. That will make interest rate rises less effective at dampening demand. One potential consequence of this is that interest rates will therefore have to rise by more and stay there for longer to achieve the same reduction on demand as in previous cycles. As a result, it is too early to rule out a peak of 6%.
Financial markets then don’t see interest rates being cut until late 2024. That seems reasonable. The exception would be that if the economy does slip into recession, as seems likely, towards the end of the year or in early 2024, the MPC would have more scope to cut rates than the market expects. But the big picture is that we’re not expecting interest rates to back to 0.1% anytime soon. A long-term rate of around 3% seems like a more likely result.
Signs of emerging labour market slack
The labour market has remained stubbornly tight despite the poor economic performance. This is primarily a supply side problem. Employment in the UK has grown by just 0.6% since Q4 2019, compared to a 1.3% growth in the US and 3.1% growth in Europe. Much of the problem is that an extra 520,000 people have the left the workforce due to sickness. That’s about 1.5% of total employment that has vanished since the start of the pandemic. The result is that wage growth in the UK is running at 7.2%, compared to 5.2% in Europe and 4.3% in the US.
However, there are signs of emerging slack in the labour market. On the supply side, the workforce has started to recover. It increased by 180K, or 0.5%, in the three months to May, due to an increase in the participation rate. While, as noted above, the number of people who are long-term sick is frighteningly high, the cost-of-living crisis has forced more students to look for work, new parents to take shorter career breaks, and many older workers to defer their plans for early retirement. What’s more, forward-looking surveys suggest that firms are finding it easier to recruit.
On the demand side, vacancies have fallen by 20% year-on-year, a good indicator that demand for employees is suffering and year-to-date redundancy notifications now are 23% higher than in 2021 and 58% higher than in 2022. Forward looking surveys are consistent with employment growth slowing to zero in the second half of this year.
The combination of these two factors has already caused the unemployment rate to rise from 3.8% in February to 4% in May.
Overall, we expect the unemployment rate to continue to rise to around 4.4% by the end of this year and stay there for most of 2024. This extra slack, combined with sharply lower inflation, will help wage growth drop to 5% by the end of the year and be back to around 3.5% in the second half of next year, the level that the MPC thinks is roughly consistent with 2% inflation.