UK Economics Update: Spending boost lowers chance of recession

The risk of a UK recession shrank today after the Chancellor announced extra fiscal spending that will also boost GDP growth by around 0.2%.

Our Q2 Middle Market Business Index, released this morning, highlighted that businesses had become significantly more concerned about the economic outlook, so a meaningful reduction in the risk of a recession will come as a welcome relief. However, the additional spending also makes it more likely that the Bank of England will raise interest rates further by the end of the year, probably to 2%.

The measures announced today amount to around £15bn of additional spending. That’s not enough to completely offset the impact on consumers of the surge in energy prices, but it will reduce the hit on disposable incomes by about 1ppt. So instead of falling by about 2.5% this year, as we previously thought, the fall is likely to be closer to 1.5%. And given most of the fiscal stimulus is going to lower-income households, we think it will mostly be spent. In economic jargon, it will ‘have a high multiplier’.

Admittedly, the government is partially funding this extra spending through a windfall tax on energy companies. But that will raise only about £5bn, and is likely to a have low multiplier. Investment spending by oil companies is relatively fixed in the short term, so the extra tax on profits is unlikely to result in lower spending today. And the Chancellor has tried to offset any negative impact on longer term investment by doubling the industry’s investment allowance.

Reducing the risk of recession and increasing consumer spending power is still likely to lead the Bank of England to raise interest rates further than it would have done without the additional fiscal stimulus, however. We wouldn’t be surprised now if the Bank raised rates another four times this year, taking the base rate to 2%. This will partially offset the positive impact on the economy from the additional fiscal stimulus but, overall, we have revised up our GDP forecast this year from 3.5% to 3.8%.