Cost of living crunch will be worse than omicron

The ONS’s announcement today that the UK was the fastest growing G7 member in 2021 may have left you wondering if there’s a ‘but’ coming. At the risk of spoiling the ending, it is.

Before we get to it, we should say that we expect all of the output lost as a result of omicron during December and January to be regained in February and March, meaning that omicron should not have had a lasting impact on the economy. 

So, here’s the ‘but’, and it’s a big one: The rebound may be relatively short-lived, as inflation will continue to rocket in the coming months, peaking at around 7% in April. Inflation and tax rises mean households’ real incomes will fall by the largest amount in three decades in 2022, which will put a large dampener on their confidence and ability to go out and spend. 

The 0.2% m/m drop in GDP in December, combined with some downward revisions to previous data, left growth in Q4 at 1.0% q/q and growth in 2021 as a whole at 7.5%. However, the level of quarterly GDP in Q4 2021 is still 0.4% below its pre-coronavirus level (Q4 2019). We’re still forecasting GDP growth of about 4.5% in 2022 as a whole.

The policy takeaway: Brace for another rate hike next month

At the margin, the smaller-than-expected drop in GDP in December makes it even more likely that the Monetary Policy Committee will hike rates in both March and May, taking them to 1.0% by the end of the year. 

Indeed, the 1.0% q/q rise in GDP in Q4 2021 was broadly in line with MPC’s February forecast. The MPC signalled on 3 February that it intended to tighten policy again in coming months if the economy evolved broadly in line with its forecasts. The MPC then expects GDP growth to stall in Q1 2022. However, today’s data suggest GDP is on course to beat that forecast.

What next? 

GDP growth will probably remain weak in January as the effects of self-isolation rules hit labour supply hard and consumers remained cautious about engaging in public life. But activity should show a swift rebound in February and March after the government withdrew its Plan B restrictions in late January. This would be consistent with the experience of the past two years, where activity has tended to rise sharply following the easing of restrictions.

Overall, we expect all of the output lost to omicron to be made up in February and March, meaning omicron won’t have a lasting impact on UK GDP. 

In fact, omicron may look like a blip compared to the looming cost-of-living crunch. We forecast annual real household disposable income will fall by almost 2%. That could be the largest fall on record. That said, there is some early evidence that households are leveraging their stronger balance sheets by saving less and borrowing more to absorb some of the hit from the surge in inflation. This should prevent some of the damage to the real economy from the cost-of-living crunch, though we expect the crunch to have a bigger impact on economic growth than omicron. As such, 2022 will be a struggle for many households and middle market businesses.

The good news is that the manufacturing (+0.2% m/m) and construction (+2.0% m/m) sectors picked up strongly as supply shortages continued to ease. The early evidence suggests that supply shortages continued to ease at the start of 2022, which means the manufacturing and construction sectors should continue their robust growth streaks.

Behind the data 

As people stayed at home in December due to omicron, restaurants and hotels output fell by 9.2% m/m, arts/entertainment dropped by 4.4% m/m and retail fell by 3.2% m/m. This was partly offset by a 2.4% m/m rise in health output and a 2.0% m/m gain in construction. 

On a quarterly basis, the 1.0% rise in GDP was driven by a 1.2% rise in consumer spending, a 1.9% gain in government spending, and a 2.2% rise in investment. Net trade added 1.6ppts to growth as exports rose by more than imports. 

In 2021 as a whole, GDP rose by a whopping 7.5% – but don’t forget that ‘but,’ and remember that GDP fell by 9.4% in 2020, which is why GDP is not back to its pre-crisis level yet.