The UK economy delivered solid growth in Q2 as consumers shook off the initial impact of the Iran conflict and higher fuel prices. Strong growth despite the energy shock raises the likelihood of the Monetary Policy Committee (MPC) hiking rates later this year. However, growth is likely to slow in H2 and the outlook for rates depends more on energy prices than growth in H1.

UK economy unfazed by initial energy shock

In June, output jumped 0.3% m/m, driven by IT, professional services and admin, which added 0.24ppts to GDP growth. Elsewhere, industrial output had a softer end to Q2. Manufacturing output fell back 0.5% as front-loading ahead of potential Iran-related price rises faded, while water supply fell 1.5% as hosepipe bans weighed on demand.

Turning to Q2 as a whole, growth came in at 0.4% q/q, beating the MPC’s estimate of 0.3%, with little sign of the real economy faltering in response to higher energy prices and elevated uncertainty. The balance of growth was reassuring, with consumption growing 0.3% as consumers smoothed through higher energy prices, while business investment surged 1.7%, offsetting weaker government spending.

All told, the economy has weathered the initial shock from the Iran war well, with little sign of activity slowing in response to higher oil prices.

Growth set to slow in second half of the year

Further ahead, we expect growth to slow to around 0.2% per quarter in H2, from 0.5% in H1, despite a likely World Cup boost in July.

First, inflation will rise back above 3% later this year as utility bills jump and higher energy prices feed through to food prices, with the latter also affected by the El Niño summer. Combined with easing wage growth, this will leave real household disposable incomes (RHDI) growing just 0.2% this year.

Second, renewed tensions in the Middle East and the prospect of another tax-raising Budget will further increase uncertainty, weighing on consumer spending and prompting firms to postpone investment. This would lead to a continuation of the stop-start pattern of recent years in which strong H1 growth gives way to a slowdown in H2.

Third, the war in Iran and concerns about the direction of fiscal policy have pushed up medium-term borrowing costs. If the upcoming Budget backloads fiscal consolidation further, markets may push borrowing costs even higher, dampening investment through the rest of this year and 2027.

Slower growth in H2 should allow the MPC to keep interest rates on hold for the rest of this year, even if strong growth in Q2 raises the risk of hikes. However, we think the MPC will be far more concerned about how energy prices develop as gas demand rises into the winter amid constrained supply.

Ultimately, the economy has proved resilient to the initial energy shock, but rebounding inflation and persistent uncertainty means growth will slow in H2. That will increase pressure on John Healey ahead of the next Budget, though limited fiscal headroom may limit how much the Chancellor can support households.

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