Despite the improved pace of economic activity in Q2, we anticipate that the cumulative effect of supply chain constraints, rising prices and the lingering challenges of the pandemic will dampen that improvement in the current quarter, and weaken overall GDP growth.
We now expect growth in the second half of the year to average 1.5%. Moreover, snarled global supply chains and the higher costs associated with it will almost surely result in a weaker pace of growth in the first half of 2022. Our revised forecast is that 2022 GDP will arrive at 4.8%, in contrast with the consensus forecast of 5.4%. The pricing in by investors of three rate hikes by the Monetary Policy Committee looks a bit optimistic, given the pace of growth implied by our forecast.
This morning’s news that GDP growth was a bit stronger in the first half of the year than previously thought is welcome. In Q2 of 2021, GDP was 3.3% below the level it was in the fourth quarter of 2019, revised up from the previous estimate of 4.4% below. But Q2 is ancient history and the data suggests that the flame of economic recovery spluttered out in Q3.
It’s also old news that GDP growth was a meagre 0.1% month-on-month in July. This was partly due to a surge in coronavirus cases requiring people to self-isolate, and partly due to rainy weather keeping them out of shops and pub gardens.
Even taking that into account, GDP growth doesn’t seem like it accelerated much in August. Retail sales fell for the fourth consecutive month, and although consumer borrowing picked up slightly it stayed subdued. Industrial production was probably weak as well, as the Society of Motor Manufacturers and Traders reports that car production fell by 27% year-on-year.
The news just got worse in September. The spike in energy prices caused some industrial firms to limit production and it will curb consumer spending, too, as people consider saving a bit more to pay off higher bills. What’s more, nationwide shortages of petrol have caused people to miss work and cancel other plans, which will further dampen economic activity. It’s not surprising, then, that the GfK measure of consumer confidence fell sharply in September.
All this suggests that growth in Q3 will be much lower than the 5.5% registered in Q2. The Bank of England has already revised down its expectation for growth in Q3 from 2.9% q/q to 2.1% q/q, but we think growth will be closer to 1.5% q/q – that would be half the rate of growth the Bank expected to see in August.
Doom and gloom aside, there is still reason to think that growth will pick up a little in Q4. Those petrol shortages are starting to ease, and the return of universities to in-person learning should help to reduce some labour shortages as students take up part time jobs. What’s more, it seems that the reopening of schools has not brought with it a rise in UK coronavirus deaths so the risk of another lockdown looks slim.
Living costs on the rise
But the challenges to growth in the medium term are stark. It’s clear both that labour shortages in some industries will remain for the foreseeable future, and that consumers are facing a cost-of-living crisis. We’re expecting GDP growth to stay around 1.5% q/q in Q4. In that case, GDP growth would be around 7.2% in 2021, but GDP wouldn’t get back to its pre-crisis level until Q1 or even Q2 next year.
The end of the furlough scheme is likely to push up unemployment because not everyone currently furloughed will be able to return to their current roles or have in-demand skills. An air steward is unlikely to take up a job as an HGV driver, for example.
Difficulties for those on reduced incomes don’t end there:
- gas and electricity prices continue to hit new records;
- the £20 a week uplift to universal credit is due to expire on 6 October; and
- workers face a tax rise of 1.25% from next April.
These factors could lower real household disposable incomes (RHDI) by 1% next year; possibly more if energy prices remain close to current levels over the winter, or if the October Budget delivers any nasty surprises.
Admittedly, households have a huge stockpile of savings – about £200bn (10% GDP) – that they can dip into to support spending. But these savings are mainly held by wealthier households who are unlikely to be affected by the reduction in universal credit, or be as sensitive to rises in energy bills.
So it will be those households with the highest propensity to spend that will be most affected. This means that most of the drop in RHDI will feed through into lower spending and, in turn, into lower GDP. As a result, we have revised down our forecast for GDP growth in 2022 from 5.5% to 4.8%.
A tricky time for monetary policy
As if labour shortages weren’t enough, it’s likely that inflation will reach 4.5% by the end of the year. It may remain high for the first few months of 2022.
This puts the MPC in a tricky position. It has to manage concerns that the spike in inflation will translate into higher inflation expectations and wage growth, leading to permanently higher inflation against a weakening economic backdrop.
The market is now pricing in three rate hikes next year and expects the Bank of England’s base rate to be above 0.5% by the end of 2022. If this happens, it would be another blow for consumers and could reduce GDP growth in 2022 by another 0.2%.
However, weaker economic growth in 2022 suggests less inflationary pressure, which may allow the MPC to get by with fewer hikes. We think the MPC will set the first hike in May. Regardless of when the MPC actually lifts rates, the committee is likely to progress slowly and cautiously. This means that interest rates will remain very low by historical standards for a long time yet.