UK - Between a rock and a hard place

The UK’s recovery from the pandemic continued to outperform expectations in late 2021 and into early 2022. The Omicron wave had a limited impact, with the government relying on voluntary social distancing, in contrast to the strict lockdowns of 2020. Since then, the authorities have gone even further, scrapping almost all remaining restrictions – including mandatory self-isolation in the event of a positive test – in a bid to ‘live with covid’. As a result, the economy finally surpassed its pre-pandemic peak in January, largely driven by growth in the pandemic-sensitive services sector. Since then, the main headwind facing the economy has moved very swiftly from the pandemic, to the war in Ukraine and the accompanying intensification of supply-side bottlenecks.

The first order impact of the war is via energy prices (see this month’s Global View). UK consumers were already due to be hit hard in their wallets via a planned rise in the household energy bill cap, which delayed the effects of earlier rises in wholesale gas prices. Energy bills will rise by some 54% in April, and this does not incorporate the most recent rise in gas prices following the Russian invasion of Ukraine – which will be visible in the next semi-annual rise in the cap, due in October. This comes alongside surging petrol, food, and other goods prices, and more moderate rises in services inflation linked to the reopening of the economy.

All told, with inflation expected to top 7% over the coming months, but wage growth rising at a more moderate 5% pace, the Office for Budget Responsibility (OBR) estimates real incomes will fall by the most since records began (c.65 years ago) on a per capita basis. The near-term concern continues to be the effect of higher inflation on expectations, and the risk of a wage-price spiral. With time, however, we think the hit to real incomes will increasingly weigh on consumption and employment. Indeed, while we have raised our inflation forecasts significantly – to 6.8% on average in 2022, up from 4.8% previously – we have also made a major downgrade to our 2022 growth forecast, to 3.9% from 5.2% previously.

All of this is turning policymaking into a tightrope act, with a need to bear down on inflation on the one hand, while staving off a recession on the other. The government has responded swiftly with support measures to ease the hit to household incomes – including cuts to fuel duty and to income taxes, which will dampen the hit to growth from higher inflation by around 0.3pp over the coming year.

Meanwhile, the Bank of England has been pushing in the other direction by raising interest rates. Already, it has moved somewhat more quickly than we expected, raising its policy rate three times since December to 0.75%. We expect a further two 25bp hikes in the coming months. However, the MPC has become more equivocal in its policy guidance of late, indicating that further tightening ‘might’ be appropriate rather than being ‘likely’ – a reflection of the significant downside risks to the growth outlook, which is likely to do most of the Bank’s tightening work for it.

Indeed, the UK faces a very different environment to the US, for instance, where inflation is being boosted not only by supply-side problems but also above-normal demand. As a result, and unlike the Fed, we expect the BoE to pause in its policy tightening in the second half of this year, as it weighs the effect of weaker growth in bringing down inflation.