Mind the gap – healthy demand, impaired supply
After an initially strong rebound from the Covid-19 mega-recession in 2020, two major shocks interrupted the UK economic upswing in 2022. First, surging gas prices caused by acute supply disruptions following the Russian invasion of Ukraine in February 2022 curtailed production and squeezed real incomes. Second, the BoE’s aggressive policy tightening to slow demand and curb the ensuing inflation dampened the flow of credit to the real economy. The result? Real GDP stalled for almost two years and the housing market slumped.
Although the gas shock badly impaired output, spending remained surprisingly resilient – even as the BoE raised the Bank Rate from 0.1% in December 2021 to 5.25% in August 2023. By 4Q23, real GDP had fallen 6% short of the 2015-19 trend but nominal GDP, the broadest measure of aggregate demand, was 5% higher – rising 11.3% over the period.
Shock absorbers – balance sheets matter
It begs the question, why did UK spending remain so strong? Part of the reason is simply that consumers and businesses had no choice but to spend more to continue to purchase essential energy to provide power for their homes and factories. But that is only half the story. Reacting to the outbreak of war and ensuing inflation shock, the prevailing view, including by BoE, had been that the UK would fall into recession. Some commentators even feared that the sudden rise in interest rates after more than a decade of rock-bottom rates could trigger an economic and financial catastrophe. All such fears proved overblown.
Instead, because banks, businesses and households had sufficiently strengthened their balance sheets in the years after the 2008 Global Financial Crisis, they could adjust to the return of interest rates to historically normal levels and absorb higher prices – see ‘In focus – UK balance sheets’ on page 8.
The downside of the UK’s extreme demand-supply imbalance in 2022 and 2023 was that inflation peaked at a higher rate (at 11.1% YoY in late 2022) than in the US (9.1%) and Eurozone (10.7%). However, now that external supply conditions are improving, the UK is benefiting from its demand-side resilience. Business and consumer expectations are surging.
The improvement in sentiment has coincided with a strong start to 2024. The 0.7% QoQ rise in real GDP in 1Q exceeded the 0.3% and 0.4% increases in the Eurozone and US, respectively.
A brighter outlook – three reasons for optimism
Looking ahead, we expect the UK economy to enjoy a period of sustained recovery growth that puts its relative performance over the forecast roughly in line with the historical norm, that is, a notch behind the US but above the Eurozone.
After a paltry 0.1% YoY rise in real GDP during 2023, we expect growth to accelerate to 1.2% in 2024, before ticking up further to 1.7% in 2025 and to 1.8% in 2026. Growth in the final year of our forecast is slightly above our 1.5-1.7% estimate of potential. Our calls are a cumulative 1.1ppt above consensus.
Our positive assessment is based on three factors:
- Improving fundamentals: Although long-run growth potential remains impaired, underlying conditions in the private sector are improving. Employment remains high and real wages are rising again after the gas shock (Figure 1). Meanwhile, productivity enhancing business investment is rebounding after the post-2016 Brexit-induced hiatus and sharp correction in 2020 during the pandemic (Figure 2).
- Fading shocks: In the UK and its key trading partners, inflation is moderating, energy markets are normalising, and financial conditions are turning easier. Together, these fading headwinds can support a cyclical recovery in domestic private demand, international trade and production. Strengthened by policy initiatives to boost supply, rebounding housing market activity can add another engine to the recovery in 2025.
- Goodbye populism: Political uncertainty surged after the UK voted to leave the European Union (EU) in June 2016. Repeated delays in Brexit and EU trade negotiations hurt confidence and weighed on investment and GDP growth while two noisy surprise elections in 2017 and 2019 further damaged the UK’s status as a safe haven. However, the worst is probably over. The 4 July election marked a de facto return to normal with Prime Minister Keir Starmer (Labour) winning a huge majority on a centre-left ticket after beating Rishi Sunak’s centre-right Conservatives.
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Figure 1: UK labour market fundamentals |
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Figure 2: UK private business investment |
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Real earnings index, 2015 = 100. Employment rate in %. Monthly data. Source: ONS |
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In real terms. Green dotted line shows long-run trend. 2016 = 100. Quarterly data. Source: ONS |
Go-slow BoE worried about sticky inflation
From 7.3% YoY in 2023, we expect inflation to moderate to 2.5% in 2024, before falling to 2.1% in 2025. In 2026, we expect inflation to tick up to 2.3% as rising demand and tight labour markets contribute to price pressures via wages. The risks to our inflation calls are unusually wide and tilted to the upside. But upside risks should not stop the BoE from cutting rates. Instead, they will shape the profile and scale of reductions in the Bank Rate.
Although headline inflation has fallen to the BoE’s 2% target in recent prints and price pressures are moderating across the board, policymakers remain concerned about some remaining stickiness in domestic price pressures as well as longer-run structural inflation risks. At 3.5% YoY in June, core inflation remained above target (Figure 3), while the 5.7% YoY rise in wages in the three months to May is probably two percentage points above the longer-run sustainable rate. Furthermore, as the final base effects from past energy price gyrations wash out, headline inflation looks likely to temporarily tick up again slightly in late 2024.
BoE policymakers have emphasised that monetary policy is tight and that it is a question of when rather than if rates will come down. Money markets put a 50-50 chance on a first 25bp cut at the 1 August monetary policy committee (MPC) meeting, when the BoE will update its forecasts in the quarterly Monetary Policy Report (MPR) and host a press conference to discuss the decision. Markets expect a second 25bp cut before year-end to take the Bank Rate to 4.75%.
We also look for two cuts in 2024, but our call is finely balanced, and the risks are skewed towards just one cut. Any one of the upcoming three meetings is ‘live’ for a first cut, in our view. In case the BoE holds in August, it would be an open question whether the bank would choose the regular meeting on 19 September or wait until 7 November at the final MPR and press conference of the year to cut. In 2025, we look for four more 25bp cuts at a pace of one per quarter. In 2026 we expect the BoE to keep the Bank Rate unchanged at 3.75% – a notch above our 3.5% estimate of the neutral rate.
The BoE’s cautious approach, which will keep monetary policy tight through 2024 and most of 2025, is likely to contribute to a slight rise in the unemployment rate from 4.1% in 2023 to a peak of 4.8% in 2025 before it declines again to a 4.5% rate in 2026 as the upswing builds pace.
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Figure 3: UK inflation and interest rates |
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Core inflation (ex. energy, food, alcoholic beverages and tobacco) in % YoY. Interest rates in %. Monthly data. Source: BoE, ONS |
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Kallum Pickering
Chief Economist
