13 July 2023
The smaller-than-expected drop in GDP in May points to a more resilient economy, making further rate hikes from the Bank of England (BoE) a bit more likely. But the data in May was clouded by the extra bank holiday and a reduction in public sector strike action. The big picture is that the economy is flatlining and the risk of a recession towards the end of the year is growing.
Most important for the BoE will be Next Wednesday’s CPI release, which will probably determine whether the Bank raises interest rates by 25 basis points (bps) or 50 bps at the next Monetary Policy Committee’s (MPC) meeting on August 3.
Behind the data
The economy contracted by 0.1% in May, beating the consensus expectation for a smaller drop of 0.3%. The reading follows a gain of 0.2% in April and leaves output 0.2% above the economy’s pre-pandemic level.
The drop in GDP on the month was concentrated in the construction (-0.2%) and production (-0.6%) industries, which likely reflected businesses shutting down on the extra national holiday to celebrate the coronation of King Charles III. In contrast, arts/entertainment output grew by 1.8% month-on-month (m/m), partly due to the celebrations.
At the same time, services output was boosted by a drop in strike action. Indeed, the number of working days lost to strike action in May dropped by almost two thirds compared to April. This helped health output to rise by 1.1% m/m and education output to rise by 0.5% m/m.
Growth is likely to flatline in Q2. Admittedly, there are reasons to think growth will pick up a little in the second half of this year. The return to a normal number of working days will mechanically boost growth, and inflation will more than halve from its current levels, which combined with strong wage growth means that households’ real incomes will start rising again.
However, rising mortgage rates will cost households at least an additional one percentage point of their disposable incomes over the rest of this year, and even more if interest rates rise to 6.5%, as financial markets expect. That will offset much of the impact of real income growth.
Overall, we expect the economy to flatline in Q2, and then meagre growth of 0.1% quarter-on-quarter in Q3. The outlook beyond that depends on how high interest rates go. A peak of 6.5% or even 7% would be more than enough to push the economy into a recession. But even if a recession is avoided, the economy is unlikely to return to trend levels of growth until 2025.