Freezing energy prices probably won't avoid a recession

It’s official: Prime Minister Liz Truss has announced that the average household’s energy bill will be frozen at £2,500 for two years. This will significantly reduce inflation in the short-term and, rather than peaking at 15% in January, inflation will rise to around 11% in October and fall back much more quickly next year. 

What’s more, the smaller impact on household incomes means that consumer spending will fall by less and the recession will be shallower. We’re now expecting a peak-to-trough drop of around 0.5% of GDP, down from 1.5%. 

There was, however, a gaping hole in the PM’s announcement because there’s still a lack of clarity around the support to businesses. That risks productive investment being deferred or cancelled and otherwise viable firms going bust, making the economy permanently smaller. 

In addition, by giving a big boost to demand at a time when the Bank of England thinks the economy, or at least the labour market, is overheating, it risks boosting inflation in the medium term, which could lead to more interest rises.

The policy will also be exceptionally expensive. The government hasn’t provided any costings yet (it will do so later in the month), but estimates are around £75bn a year (3% GDP) for two years so £150bn in total – that’s twice the cost of the furlough scheme. And it could be even more expensive if gas prices move higher during the winter. That will make it very difficult to cut taxes by any significant amount later in the year. 

Near-term inflation lower, but interest rates may end up higher 

The new energy price cap means that inflation is probably already close to peaking. We now think inflation will rise from 10.1% in July to around 11% in October and November before falling back sharply over the next year. 

By guaranteeing lower inflation for the foreseeable future, the cap could also reduce medium-term inflation expectations, which have been drifting in recent months. This suggests that the Bank of England will need to lead less heavily against inflation in the short-term. 

However, that is unlikely to stop the Monetary Policy Committee (MPC) from raising interest rates next week. There is more detail in our MPC Preview but, in short, a stubbornly tight labour market, soaring inflation and wandering inflation expectations mean the MPC will probably opt for another 50bps hike at its next meeting on Thursday, 15 September – despite its own forecasts that the economy will fall into a recession by the end of the year.

Further ahead, a huge fiscal stimulus will also boost demand for domestic goods, services and labour. This is likely to keep inflation higher in the medium term and give support to core inflation, which excludes volatile energy and foods prices. 

In addition, by avoiding taking action to insulate businesses from surging energy prices, the ‘second round effects’ (whereby businesses pass on surging energy costs to their customers) will continue to push medium term inflation higher. Indeed, in August the MPC estimated that second round effects would add at least 1ppt to inflation in October. And yesterday the Bank of England’s Chief Economist, Huw Pill, said that the Bank is there to ensure that fiscal policy “does not generate inflation”. So looser fiscal policy will probably just lead eventually to tighter monetary policy.

That suggests that interest rates will have to go higher in the longer term to get core inflation back to the MPC’s 2% target. We now expect interest rates to peak at 3.5% by the end of next year. 

 Smaller recession – but still a recession 

The hit to household’s incomes will now be smaller than we previously thought. Real household disposable incomes are now likely to fall by roughly 2.5% in 2022 and by about 1% in 2023. That’s much better than the 3% fall both this year and next that we were expecting, but it is still a significant drop. 

Inevitably, consumer spending will fall as a greater share of households’ resources are diverted towards energy bills. That will lead to a recession at the end of this year and an extended period of weak growth.

But bear in mind that not all recessions are created equal. In August, the Bank of England forecast that the recession will begin in Q4 and last all the way through 2023, with a peak-to-trough fall in GDP of around 2%. That would put it on a par with the early 1990s recession. We now think the drop will be closer to 1%, making it the mildest recession since the 1960s and significantly smaller than the Global Financial Crisis, which had a peak-to-trough drop in GDP of around 6%, and have only a fraction of the pandemic’s economic impact when GDP fell by 22%!

However, there is a still a huge question mark over support to businesses. Businesses and public sector bodies like schools would receive “equivalent support” to households — but only for six months. Presumably this means that their energy costs will be capped at the equivalent cost per unit of energy, but the details are much less clear.

And even then this support will only last for six months. After that, Ms Truss said that ongoing support would focus on “vulnerable industries”.

The uncertainty around the business cap is unlikely to support business investment. The UK has the lowest business investment in the G7. For example, UK business investment is still almost 10% below its 2016 level compared to business investment in the US, where it is almost 25% above it. Lack of investment is a key factor in the UK’s poor productivity growth over the last decade.

What’s more, the RSMUK MMBI found another concerning drop in the proportion of firms saying they were increasing capital expenditure, from 38% in Q1 to 34% in Q3. And the percentage of businesses expecting to invest more over the next six months dropped to 42%, by far the lowest reading in the RSM UK’s MMBI history.

Not only will a lack of business investment make the recession deeper, but it will also make the UK economy permanently smaller. This will make it harder to pay back the UK’s borrowing, and more difficult to improve its dire productivity.