The 0.6% month on month (m/m) drop in GDP back in September means that GDP fell by 0.2% quarter over quarter (q/q) in Q3 this year. This probably marks the start of a recession that will last until Q3 2023. We will likely see GDP fall by about 2.5%, as the cost-of-living crisis is compounded by a cost-of-borrowing crisis and austerity mark 2.
Consumer spending leading the way down
Admittedly, the ONS estimated that at least half of this month's fall in GDP is because of the bank holiday for the Queen’s funeral, which led to widespread business closures. This suggests that the underlying real GDP fell by around 0.3% m/m in September, and that in Q3 as a whole it declined by around 0.1% q/q.
However, the underlying driver is undoubtably the cost-of-living crisis. Consumer spending fell by 0.5% q/q as households’ real incomes were squeezed by soaring inflation. And business investment also fell by 0.5% q/q as a weaker outlook for demand and rising interest rates makes investment projects less lucrative.
This does not bode well for future economic growth. The UK is already at the bottom of the pack for business investment. This lack of investment is a key reason why UK productivity is so poor. When demand starts to pick up again in 2024, the middle market firms that have continued to invest through the recession will be in a far better place than those who have sharply cut investment.
The drop in consumer spending was partially offset by a 1.3% q/q increase in government spending, a 2.5% q/q rise in total investment (as a 7.6% q/q jump in government investment and a 4.9% q/q rise in housing investment more than offset the 0.5% q/q fall in business investment) and a whopping 8% q/q rise in exports.
The breakdown of the monthly GDP shows the September contraction was entirely led by services, down by 0.8% on the month. That reflected material falls in information and communication, as well as wholesale and retail sale. Consumer-facing services posted another monthly drop of 1.7%, as retailers report the impact from rising prices. Consumer-facing services are now 10% below their pre-pandemic level.
Construction and industrial production helped offset the services drop. Construction was up by 0.4%, the third straight month of growth, while industrial production increased by 0.2% - mostly reflecting energy supply.
As the effects of the extra bank holiday will have dropped out, GDP may rebound and turn positive again in October and at the start of Q4. However, that won’t be enough to prevent GDP falling again later in Q4.
The squeeze on household real incomes will intensify as rising interest rates join soaring inflation. What’s more, in the upcoming Autumn Budget - and the anticipated return of austerity - Chancellor Hunt is expected to impose around £50bn of tax rises and spending cuts. This means that government consumption will start to be a drag on GDP, while the huge rise in business borrowing costs will weigh heavily on investment. In addition to that, a global economic recession means that large rises in export volumes are unlikely to continue.
The big risk is that a severe shift towards growth-damaging austerity measures, such as cutting benefit payments or government investment, will prolong the recession or dampen the recovery (as we saw after the Global Financial Crisis).
However, not all recessions are created equal. We expect a peak-to-trough fall in GDP of around 2.5%. That would be slightly smaller than the early 1990s recession, significantly smaller than the Global Financial Crisis (which had a peak-to-trough drop in GDP of around 6%), and a fraction of the pandemic when GDP fell by a massive 22%.
The big picture is that the economy could be no larger in 2025 than it was in 2019, before the pandemic.
For the Bank of England, today’s data will come as a somewhat pleasant surprise - it was expecting a fall of 0.5%. However, we doubt the figure will have a material bearing on what comes next for policy – the labour market and inflation data will be the biggest determinant of whether the central bank steps down the pace of hikes in December.
The broader point is that the Monetary Policy Committee thinks a recession is needed to cool inflation in the UK, so it’s unlikely to be an impediment to rate hikes until inflation and wage growth shows clear signs of turning a corner.