The UK economy smashed expectations again in July, suggesting the economy now has some genuine momentum despite higher energy prices squeezing real incomes. As a result, Q3 growth now looks likely to be much stronger than the Monetary Policy Committee’s (MPC) downbeat 0.1% forecast, increasing the likelihood of a rate hike later this year. However, the risks remain skewed towards slower growth as higher energy prices push inflation towards 4% and prompt real wage growth to turn negative. In the near-term, we now expect GDP growth of 0.4% in Q3, up from 0.2% previously.

Strong GDP growth driven by IT and admin

The UK economy surged by 0.4% in July, after output already jumped by 0.3% in June.

Growth was driven almost entirely by IT and administrative services, which contributed 0.34ppts. The ONS suggests that firms in the IT sector are benefiting from AI-related and cloud computing activity, which should continue to underpin activity. Granted, these sectors are volatile and administrative services have risen by 5.6% in just two months, so we still expect some payback over the coming months.

However, consumers had a weaker month with consumer-facing services falling by 0.4% as retail activity fell by 1% and hospitality only rose by 0.2% despite the World Cup. Anecdotal evidence suggests that consumers switched from restaurants to pubs rather than increasing the total amount of spending.

Overall, the economy continued to outperform expectations despite renewed tensions in the Middle East. Even if business services give back some of July's gains in August, strong growth in July means we now expect GDP growth of 0.4% in Q3, up from 0.2% previously.

UK economy still likely to slow later this year

Further ahead, we still expect growth to slow in the final months of the year for three reasons.

First, renewed tensions in Iran have pushed energy prices higher, meaning inflation is now likely to rise to around 4% in Q4 and remain elevated into early next year as utility bills reset. Combined with a weak labour market, this means real income growth is likely to be negative later this year and in turn drag on consumer spending.

Second, the prospect of another tax-raising Budget in October will add to already elevated uncertainty and could prompt firms to delay investment and households to postpone major purchases. This would lead to a continuation of the stop-start pattern of growth in recent years where activity slows sharply around the Budget.

Third, the recent surge in gilt yields, which set the cost of borrowing for the private sector, means that mortgage rates and business loans will reset higher and drag on activity over the coming quarters. What’s more, if the Chancellor opts to backload fiscal consolidation even more then financial markets may respond by pushing borrowing costs even higher.

In any case, strong output growth in July combined with inflation heading to 4% raises the risk of a rate hike from the Bank of England later this year. That said, we think the MPC will prefer to wait and see for more evidence that second-round effects are becoming likely, so we expect the Committee to hold rates in September, with a hike in December looking likely if growth continues to surprise to the upside.

For the MPC, strong GDP growth increases the risk of a rate hike later this year. However, we expect the MPC to wait for more evidence that second-round effects are likely before acting. So, we continue to expect rates on hold in September, but the risks of a hike at the end of the year are rising.

Ultimately, the economy has weathered the initial energy shock better than expected, but rising inflation, a weak labour market and persistent uncertainty mean the risks remain skewed towards a sharp slowdown later this year. That will increase pressure on John Healey to find ways to support households, but the tight fiscal position may limit how much the Chancellor can do.

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