UK - Stagnant GDP and sticky inflation to keep rates higher for longer
The UK looks to have dodged a technical recession, but the outlook remains bleak.
GDP eked out 0.1% q/q growth in Q1, following 0.1% growth in Q4. In level terms, the UK is the only major advanced economy with GDP still below its pre-pandemic level, with output languishing some 6 percentage points below the pre-pandemic trend. Output was weighed in Q1 by a wave of public sector strikes, which led to declines in health, education and transport output. This offset comparative resilience in goods-producing sectors and construction, which rose 0.5% and 0.8% q/q respectively. Customer-facing service sectors such as travel and recreation stagnated, weighed by the hit to real incomes from high inflation and an increasingly heavy burden from high interest rates (UK households hold a much bigger share of floating or short-term fixed mortgages than in many other countries and so are more vulnerable to high rate).
Despite the weakness in the economy, the easing energy crisis has meant GDP has surprised somewhat positively of late. As a result, we have raised our 2023 growth forecast from 0.1% to 0.3%. However, this is more than offset by a significant downgrade to our growth forecast for 2024, by a full percentage point to 0.7% from 1.7% previously. This is due to the expected stickiness in inflation, and the therefore reduced likelihood that the Bank of England will be able to ease monetary policy this year (see below). In the near-term, output could see support from somewhat reduced public sector strike activity and a pickup in investment due to new government fiscal incentives. However, in big picture terms we expect tight monetary policy to keep a firm lid on output over the coming 18 months.
May was probably the last BoE hike of the cycle…
The Monetary Policy Committee yesterday raised Bank Rate today by 25bp to 4.5%, in line with our and consensus expectations. The Bank also significantly raised its growth and medium term inflation forecasts, and now no longer expects a recession but instead a prolonged period of stagnation. In its guidance for the future path of rates, the Bank kept the more conditional language from its March meeting, stating that if “there were to be evidence of more persistent [inflation] pressures, then further tightening in monetary policy would be required.” While wage growth has surprised to the upside of late, leading indicators for wage growth suggest that it has peaked, and despite the upward revision to GDP growth, the MPC appears to think that stagnation combined with only a small rise in unemployment (around 0.5pp) will be sufficient to bring inflation sustainably back to target.
Indeed, when questioned on this directly, Deputy Governor Ben Broadbent argued that much of the upward pressure on wage growth was linked to workers seeking to make up the hit to real incomes from the energy crisis rather than it being the result of the tight labour market, and that with the energy crisis now receding, wage growth was expected to normalise without a big rise in the unemployment rate. We have our doubts about this prognosis – and, absent a recession, we see a risk that wage growth and therefore inflation settles at levels above the BoE’s 2% target. With that said, the MPC appears minded for now to adopt a wait-and-see approach. Given this, and in the absence of a further uptick in wage growth, we think this may now be the final hike of the cycle. At future meetings, an MPC pause will likely be bolstered by the expected significant fall in headline inflation (largely on the back of the drop in household energy bills).
…but rates to stay higher for longer
While we think the BoE may have reached a peak in rates, the less weak near-term growth outlook combined with a more shallow expected rise in the unemployment rate means that wage growth and core inflation is likely to prove stickier. We have therefore pushed out our expectation for the start of rate cuts to Q2 2024 from Q4 2023, and significantly raised our end-2024 expectation for Bank Rate, to 3.75% from 3% previously.