UK: Steeper rate rises, despite recession risks

This is part of the Global Monthly, see here

The UK economy is expected to contract in Q2, as the unwind of pandemic-related health service activity (eg. NHS track & trace) offsets the broader recovery in the services sector. The economy should rebound subsequently, as the holiday season and the end of pandemic restrictions drives a strong recovery in travel over the summer months. However, beyond this we have significantly downgraded our growth forecast, principally for 2023. This is due to the rise in inflation risks, which are showing increasing signs of spreading to the labour market. This week, rail union TSSA negotiated a 7.1% pay rise for Merseyrail staff, amid a wave of strikes hitting the railways across the UK at present, while the minutes from the Bank of England’s June policy meeting noted that a ‘significant minority’ of companies were reporting ‘mid-year top-ups to pay’, likely in response to high inflation. Such developments are naturally causing greater worry among members of the Bank of England’s Monetary Policy Committee that inflation might evolve into a more entrenched and self-sustaining wage-price spiral. To pre-empt this risk, we now expect June’s 25bp rate hike to be followed by a bigger 50bp move by the BoE in August, and we significantly raised our forecast for where we expect Bank Rate to peak, to 2.5% from 1.5% previously.

Steeper rate rises will add to existing downside growth risks coming principally from inflation itself, which is driving the biggest fall in real incomes on record. Among other things, this is keeping retail sales below trend, despite the significant savings buffer that households built up during the pandemic. Alongside the US and the eurozone, we expect this buffer to gradually erode over the coming year, as inflation continues to eat into real incomes. In the meantime, rate rises will naturally have a dampening effect on demand, with the red-hot housing market expected to cool, and fixed investment growth to fall back. All told, we expect the economy to slow to a crawl next year, with growth of just 0.3% projected, down from our previous expectation of 1.6%, and from a downwardly-revised 3.6% expectation (previously 3.8%) for 2022. The economy will likely be on the cusp of a technical recession next year, with unemployment expected to rise to nearly 5% by the end of 2023 from the current historically low 3.8%.

Will the BoE need to cut rates once the inflation hump has passed?

The peak we now expect in interest rates is still well short of current market pricing, which foresees the BoE raising Bank Rate to over 3% by next May. We think that by later this year, the economy should have sufficiently weakened to drive a rise in unemployment and a cooling in wage growth. Combined with a broader fall in inflation in the first half of next year, this could raise the prospect of the MPC reversing course and cutting rates to support growth, perhaps in H2 2023. Indeed, the MPC’s projections from May – which were predicated on market pricing for Bank Rate to peak at 2.5% – pointed to a significant rise in unemployment and an undershoot of the 2% inflation target in the medium term (see here). Unless the Bank’s internal neutral rate estimate has changed, this suggests rates are unlikely to stay this high for very long.