Economy update: Storm clouds gathering despite Q1 growth

Despite surging inflation and rapid rises in interest rates, the UK economy has shown more resilience than expected of late. As recently as November, the Bank of England (BOE) forecast that the economy would contract in the second half of 2022 and remain mired in recession through the first half of 2024.

In the event, after declining in Q3 2022, the UK economy expanded modestly in both Q4 2022 and Q1 2023, business confidence has improved sharply in the key services sector, and the unemployment rate has remained very low. The economy has benefitted from falling energy prices, improving global supply chains, and better than expected global growth.

Storm clouds are gathering though. Despite aggressive monetary tightening, inflation remained significantly above target in May at 8.7%, well above levels in the US and Euro area (Chart 1). Moreover, core inflation, which excludes food, energy, alcohol and tobacco prices, rose from 6.8% to 7.1% – the highest since March 1992.

The latter is closely followed by policymakers, as it better reflects underlying price pressures in the domestic economy that are driven by developments in wages and price setting by firms. With pay growth surging amid a very tight labour market, core inflation looks unlikely to ease significantly anytime soon. Hence, without additional interest rate increases that weaken the economy, inflation is likely to remain well above target, and there is an increasing risk of an accelerating wage-price spiral.

Concerned about recent inflation-related data and rising risks to its credibility, the BOE Monetary Policy Committee moved decisively at its June meeting, raising interest rates by a larger than expected half a percentage point to 5% – the highest since 2008. Seven members voted in favour, two again opted for no change in rates. The majority argued that recent strength in wages and services inflation indicated a greater persistence in the inflation process.

It was the final meeting for one of the two dovish dissenters, Silvana Tenreyro, and recent comments suggest her successor, Megan Greene, is likely to be of a more hawkish persuasion. The committee said it would watch developments closely and stands ready to act again if there were evidence of more persistent inflation. Financial markets are expecting a peak in rates of around 6%. The balance of risks clearly points in the direction of further policy tightening, and rates are likely to remain elevated for an extended period.

Monetary policy works with a lag of up to two years, and the cumulative impacts of current and past tightening will increasingly bear down on the UK economy and housing market. Only around 15% of mortgage holders are on variable rates, the rest typically fix their rates for two years or increasingly five years.

According to ONS calculations, over 1.5 million mortgages are due to reset before the end of 3Q 2024, of which over 40% and almost 50% were on initial fixed mortgage rates of less than 2% and between 2-2.5% respectively (Chart 2). These mortgages will have to renew at dramatically higher rates.

Estimates by the Resolution Foundation suggest that the average mortgage re-setter in 2024 will be worse off by £2,900, which will clearly hit household consumption hard. The risk of rising mortgage defaults will also increase, although with banks agreeing to work with struggling homeowners, and absent a large increase in the unemployment rate, a major vicious cycle of forced selling may be avoided.

The pain of rising prices and tighter monetary policy is also being felt by businesses. Interest rates on loans have increased sharply, and corporate insolvencies in 2023 are running more than 10% higher than 12 months earlier.

The economic backdrop will be a difficult one for PM Rishi Sunak to seek re-election in 2024. The government appears to have ruled out direct financial support to struggling mortgage borrowers, given fears it could exacerbate inflationary pressures. Surging borrowing costs on the government debt also significantly reduce its room for manoeuvre, including to cut taxes next year.

Ultimately, key for the UK economy are structural reforms that boost its potential to grow without generating inflationary pressures. Such policies typically take time to bear fruit though, and some would undoubtedly be unpopular with the government’s supporters.

All in all, it is looking like an increasingly tough backdrop for the UK economy over coming quarters, with risks of a recession increasing sharply. It will be important for accountants to alert their companies and clients to the various risks. Meanwhile, we will be closely scrutinising the results of our upcoming quarterly Global Economic Conditions Survey of accountants and CFOs for signs of stresses building in the UK and global economies.