13 January 2023
There is now a chance that overall growth in Q4 might be positive, if GDP falls by less than 0.4% m/m in December, after the surprise 0.1% month on month (m/m) rise in GDP in November (consensus -0.3% m/m). A drop of that magnitude in December is certainly possible, given that all the main business surveys point to falling production, and both heavy snowfall and, to a lesser extent, rail strikes, likely weighed temporarily on activity. But there is now a good chance that the official definition of a recession of two consecutive quarters of negative growth might not be met until Q2 of this year.
Of course, that doesn’t change much on the ground. For businesses operating in the real economy, a rise in GDP of 0.1% doesn’t feel much different to a drop in GDP of 0.1%. But a milder recession would mean that unemployment rises more slowly, wage growth stays strong and domestically generated inflation falls more slowly than expected. This could result in the Bank of England (BoE) raising rates by more than expected.
Consumer spending unexpectedly strong
The unexpected rise in GDP in November was down to the strength of the services sector, where output rose by 0.2% m/m. Consumer spending has remained strong, even in the face of a record-breaking cost-of-living crisis. Output in consumer-facing services grew by 0.4% in November 2022, following growth of 1.5% in October. The largest contribution to growth came from food and beverage service activities. Admittedly, this is probably partly due to the start of the World Cup. But consumers have shown a clear preference for spending on experiences rather than goods with spending on hospitality holding up much better than retail sales.
There was also strong growth in the administrative and support activities (+2%) and information and communication (+1.7%) categories.
In contrast, the manufacturing industry remains in the doldrums with output falling by another 0.5% m/m, mainly due to a sharp drop in pharmaceutical manufacturing. And output in the construction industry was also flat, with strong growth in infrastructure offset by falling housebuilding.
The economy seems to be holding up relatively well amid the sharp squeeze in household real incomes and the rapid pace of monetary policy tightening. It will be touch-and-go as to whether GDP falls by enough in December for GDP to contract in Q4.
However, we continue to think that GDP will drop substantially in Q1 and Q2. The Government has temporarily stopped paying cost of living grants to low-income households in Q1, and will substantially reduce its energy price support in Q2. What’s more, consumer confidence is still near its-record lows, which will prevent households from lowering their still high saving ratio.
Meanwhile, the Monetary Policy Committee’s rapid rate hikes have dramatically increased the cost of external finance for corporates, who mainly have floating rate loans.
As a result, we still expect GDP to fall by around 1.5% this year, meaning this recession would see a peak-to-trough drop in GDP of roughly 2%. That would be slightly smaller than the early 1990s recession, significantly smaller than the Global Financial Crisis (which had a peak-to-trough drop in GDP of around 6%), and a fraction of the pandemic when GDP fell by a massive 22%.
But, the big picture is that the economy could be no larger in 2025 than it was in 2019, before the pandemic.
Two recent developments present a bit of a challenge for the Bank of England. First, the sharp drop in energy prices over the last month means headline inflation could be 1 percentage point (ppt) lower by the end of 2023 than previously expected. That’s a positive for the Bank. The flip side is that more buoyant demand would boost underlying inflation, raising the risk that interest rates must stay higher for longer and the recovery from the downturn would prove painfully slow.
Second, a shallower recession, either because energy prices stay low or because consumer spending is stronger than expected, would mean that domestically generated inflation is higher. The Bank may then need to offset this by raising interest rates by more and keeping them there for longer. We expect rates to peak at around 4.25%.