UK - Labour market remains resilient, despite weak growth

Sluggish growth ahead

The UK escaped a technical recession in 2022H2 by the tiniest of margins, with GDP flat in 2022Q4 after an upwardly revised -0.2% q/q print in 2022Q3. The better-than-expected GDP growth outturn follows welcome developments in the wholesale gas markets, where prices have dropped to levels similar to the period immediately before the war in Ukraine. Set against this positive news are a number of headwinds that will continue to bear down on the economy in 2023. The most important of these is monetary policy, which is within the restrictive territory range. Second, fiscal policy is set to turn restrictive as taxes rise. Finally, the external environment is challenging, with weak economic growth in the eurozone and the US. Taken together, we expect annual GDP growth at -0.8% in 2023 and 1.2% in 2024 (after 4.1% last year), with growth particularly weak in the first half of this year and a sluggish recovery thereafter. More structurally, the key challenge for the UK remains low labour productivity, with output per worker some 16% below the G7 average (excluding Japan and UK) in 2021 and productivity growth (output per hour) averaging just 0.7% per annum between 2014-19.

Strikes pose a material risk to our inflation and monetary policy forecast

Headline CPI inflation fell for the third month in a row in January to 10.1% yoy (from 11.1% in October). Inflation is expected to fall further, as the sharp increase in imported commodity and energy prices from last year drop out of the index. The overall price level will nevertheless remain high, even after the reduction in commodity and energy prices, reflecting the permanent adverse terms-of-trade shock suffered by the UK (the largest since the 1970s).

The main uncertainly to the inflation outlook however, relates to core or service sector inflation, which is closely linked to developments in the labour market and more particularly, to wage growth and productivity. The labour market in the UK remains tight, despite the recent slowdown in economic activity. The unemployment rate rose marginally to 3.7% in 2022Q4, as did average total pay which, at 5.9%, is the strongest outside the coronavirus period and well above the level consistent with inflation at 2%. In our view, employment and wage pressures will ease over the course of the year in response to sluggish economic growth, but the risks to wages are tilted to the upside because of ongoing industrial action by workers in key sectors of the economy – health, transport and education (See UK wage-price spiral?)

The Bank of England raised its policy rate by 50 basis points earlier this month, to 4%. The current rate hiking cycle which started in December 2021 with Bank Rate at 0.1% is the most aggressive since the BoE was granted operational independence in 1997. We forecast just one additional rate increase of 25bp in March although the risks to our inflation and monetary policy forecast are tilted to the upside because of labour strikes. We estimate that inflation could be around 0.2-0.8pp higher over the next 2-3 years if the government negotiates higher public sector pay, with an upside risk to Bank Rate to the order of 25-100 bps.

This article is part of the Global Monthly of 24 February 2023