Now is clearly not the time to grow complacent about the pandemic. However, as the economy approaches its pre-pandemic level, we expect it to grow strongly. We think that 2022 will see a transition towards a hypercompetitive post-pandemic economy that features:
- tighter monetary policy, intended to address risks around higher inflation;
- improved capital expenditures that will support rising productivity; and
- a transformation of the UK workforce that includes higher wages, more workplace flexibility and the long-awaited rise of the millennials into management and major decision-making roles.
We also expect that:
- economic growth during the coming year will be almost 5%;
- the unemployment rate will decline to an average of 4.1%; and
- employment to grow by roughly 50,000 a month.
While there are likely a wide range of possible outcomes around the risks to the outlook linked to the Omicron variant and the rate of growth, employment, inflation and monetary policy we do not at the current time see a need to alter our forecasts.
Inflation will peak at 5% in the second quarter of next year and will remain high over the summer, before falling rapidly in the second half of the year and early 2023. This will allow the Bank of England to slightly tighten monetary policy over the course of the year.
The accommodative monetary policy and robust fiscal support, which underscored the pandemic era and continue to bolster growth, are likely to fade during 2022. The several major risks on the horizon will then be more clearly revealed.
The first risk is that the Omicron variant of coronavirus leads to another surge in cases, either in the UK or in its major trading partners. The second is that, even if the Omicron variant never takes off, supply chains still take longer than expected to unsnarl, and inflation remains higher for longer than anticipated. How policy makers respond to these challenges will largely determine how the economy develops in 2022.
But we think 2022 is likely to mark the shift from an economy that’s overly determined by public health conditions linked to the pandemic, to one learning to live with an endemic illness that does not represent an outsized risk to the overall economic activity.
Base case and the UK economy
Our base case is that the UK economy will expand by 4.8% year-on-year in 2022. The first half of next year is likely to be marred by continued materials and labour shortages, as well as surging inflation, so growth will stay subdued. But demand is strong, so middle market firms should be ready to ramp up production as pandemic-related shortages ease.
That said, the risks are weighted to the downside if there are more lockdowns, shocks to the global supply chain prove longer lasting, or if energy prices push up inflation by more than we expect. What’s more, if the Bank of England does what the financial markets expect and raises interest rates to 1.0%, growth will be lower than it might otherwise be in 2022 and 2023.
The composition of growth will remain heavily tilted towards consumer spending, as households continue to release the pent-up demand build up over the last two years. Admittedly, households’ real disposable incomes will probably fall slightly in the first half of next year as a result of high inflation, benefit cuts and tax rises. Even so, it can’t be ignored that households have accumulated about £200bn (10% of GDP) in excess savings that can be used to supplement spending. We expect consumer spending to grow by a little over 7% year-on-year in 2022.
Business investment will be the other major growth driver. It was held back in 2021 by supply side issues, meaning that firms were unable to get their hands on the equipment they needed. But firms are in a good position to invest. In fact, the value of Private Non-Financial Corporates’ Sterling cash holdings with UK banks was £140bn higher in Q2 than it was pre-coronavirus – that’s equivalent to 60% of business investment in 2019.
In addition, a large backlog of projects is likely to have accumulated over the last 18 months, especially now that many businesses are capacity constrained. We expect business investment to grow by about 10% year-on-year in 2022, which will set the economy up for stronger sustained growth in the future. As a result, total investment will probably rise by close to 6% in 2022.
Inflation: Reaching the summit
Inflation will probably peak at about 5% in April and remain high for a few months after that. But it will drop back to 2% in early 2022 as the recent rise in energy prices fades. The big risk is that inflation sharply undershoots in 2023 if energy prices drop back.
Three main factors drove the surge in 2021 inflation. The first were base effects, pushing up the headline rate. Because inflation compares prices now with their level a year ago, the late 2020 pandemic-induced drop in many prices is boosting the rate of inflation now.
Second, global energy and fuel prices have surged. Wholesale natural gas and electricity prices in the UK have both risen by almost 300% since this time last year, and oil prices are up by 125%.
Third, supply chain chaos has caused the price of some goods to spike. For example, the price of a used cars has risen by 22.9% as pandemic-induced shutdowns dried up the worldwide supply of new cars.
We already know that the same factors that have driven up inflation so far this year are going to keep pushing it up to a peak of about 5% in April. That’s because there are predictable lags between rises in energy and food commodity prices and their impact on inflation. The much more interesting question is what happens after April.
Once it peaks, inflation will remain high through the first half of 2022. It should then fall sharply in the second half of the year as the recent surge in energy prices falls out of the annual comparison. Our base case is that inflation will be around 2.5% by the end of 2022, and fall to 2% in early 2023.
Of course, there is a risk that energy prices will continue to rise over the winter or that supply chain pressures will take longer to resolve than we think. Indeed, with stress still quite evident inside our proprietary RSM UK it is clearly premature to call a bottom in the global supply chain crisis or to ignore topline inflation data. What keeps the MPC up at night is the risk that the recent burst of high inflation leads to inflation expectations coming unstuck. The result could be employees demanding higher wage settlements and permanently higher inflation. Luckily, longer-term inflation expectations have only risen slightly, so the risk of higher inflation becoming entrenched is small.
However, the risks to inflation are not only on the upside. In fact, it’s much more likely that inflation is going to undershoot the 2% target in 2023 than overshoot it. The commodity futures markets point to falls in the prices of energy commodities – inflation could be just 1% in 2023 if gas and electricity prices fall by 20% and used car prices return to normal by the middle of 2022.
Labour market: Full steam ahead
The UK economy is experiencing something of a revolution in the workplace which has been accelerated by the pandemic. Everything from remote work, lack of labour and higher wages is starting to transform the British workplace and workforce. We expect those changes to accelerate in 2022 amid a tight labour market and a return to full employment.
The UK labour market has had a remarkable recovery over the last year, with the unemployment rate peaking at 5.2% and returning to 4.3% in September. But this still leaves the domestic labour market short of roughly half a million workers compared to pre-pandemic levels. The recovery in the labour market is likely to continue in 2022 as employment grows by about 50,000 a month.
However, lower levels of net immigration as a consequence of Brexit and the pandemic may mean that the workforce grows at a slower rate than previously. The result of strong demand for labour and limited growth in the workforce is that the unemployment rate should drop. We think the unemployment rate will drop to 4% by the end of next year. That would be only a little higher than the 3.8% registered before the pandemic. As a result, through 2022 we expect nominal underlying wage growth to remain relatively strong at between 3% and 4%.
When the Monetary Policy Committee (MPC) deliberates over its monetary policy for next year, the condition of the labour market will be almost as important a consideration as the outlook for inflation.
Policy considerations: Monetary and fiscal policy
As long as the Omicron variant doesn’t lead to further lockdowns, the MPC will probably tighten monetary policy in 2022, but we think the market is mistaken in expecting interest rates to rise to 1% by the end of 2022. Instead, at this time next year we expect the Bank rate to be 0.5%.
Andrew Bailey, the governor of the Bank of England, has come under heavy criticism for issuing poor guidance on the direction of interest rates. This criticism partly just highlights the delicate balance that the MPC will have to strike over the next year. Inflation is likely to reach 5%, more than twice the MPC’s 2% target, but there’s not much the MPC can do about the largely external factors driving inflation, such as energy and shipping prices, and the fact that disposable household incomes are already under pressure.
To us it seems most likely that the MPC will raise interest rates from 0.1% to 0.25% in December, but this first hike could easily come in February instead. Whenever the MPC first raises interest rates, though, it will proceed slowly and with caution. What’s more, the MPC has said that once interest rates reach 0.5% it will stop reinvesting the proceeds of its asset purchases. That would begin to shrink the Bank’s balance sheet and would tighten monetary policy. We think the MPC would want to see the economy’s reaction to this before raising interest rates further. At the same time, inflation will start to fall quickly in the second half of 2022, reducing the need for further rate hikes.
We think Bank rate will be 0.5% by the end of next year, which would still leave real interest rates, which take inflation into account, extremely negative.
The measures announced in the Budget in October 2021 mean that government spending will have a smaller drag on the economy in 2022. Government spending should stabilise at just under 42% of GDP by 2024-25 – around 2ppts higher than the average between 2010-15. Indeed, a larger state is likely to be one of the permanent legacies of the pandemic.
However, the Chancellor will still have a bit of headroom against his new fiscal targets, meaning he may be able to reduce taxes closer to the next election in 2024.
We expect the yield on ten-year gilts to finish 2021 at around 1%, and think they’re likely to rise to 1.25% by the end of 2022. Indeed, falling inflation in the second half of next year should mean that the break-even inflation rate component of gilt yields reversing some of its recent sharp rise. Gilt yields may not rise by very much at all if we’re right in thinking that Bank rate will be closer to 0.5% than 1% by the end of next year.
Given that we think the financial markets are pricing in too many rate hikes, our forecasts imply that the pound is more likely to weaken than strengthen against the dollar and the euro. In addition, Brexit is once again generating an extra downside risk.
On the assumption that there are no more lockdowns, equity prices should continue to recover. Indeed, to the extent that the stock market is a function of corporate earnings, we expect the growth of the economy in the post-pandemic environment to sustain returns on equity-market investments.
Currently, the RSM UK Financial Conditions Index stands over 1 standard deviation above neutral – implying that sentiment remains skewed towards risk assets as bond prices fall and yields rise in fixed income products.