The UK economy is still growing slowly thanks to the boost to households’ real disposable income resulting from lower energy prices, which have more than offset the drag from higher mortgage costs.
But consumers remain cautious, and businesses are rationalising their hiring and investment decisions. This has resulted in a weakening of the labour market, with unemployment on the up.
Meanwhile, inflation might be falling overall, but food inflation has been slow to ease and oil prices remain volatile. So does the Bank of England’s (BoE’s) decision not to hike rates in September mean its ending the tightening cycle?
Economic growth oscillating around a gently rising trend
The UK economy contracted by 0.5% in July, but this reflects one-off factors rather than inherent weakness. Output in the health and education sectors fell sharply due to strikes, which should now be over, while lower output in the distribution and hospitality sectors probably reflects poorer weather dampening demand.
In fact, the latest data revisions show that the UK economy has grown faster than Germany and France in the post-Covid period. Even better, growth in Q2 was led by resilient spending by both consumers and businesses. Some support also came from a rise in government spending, but weakness in trade remains the UK’s Achilles heel.
The outlook is still for sluggish growth this year, followed by a marginal pick up in 2024. Purchasing Managers’ Indices (PMIs) are pointing to a downturn in private sector activity, with the composite PMI at 48.5 in September. That said, the future activity sub-index was at 69.0, compared with 68.9 in August. It seems that businesses are hopeful that an anticipated decline in inflation will support broader economic activity.
Steady improvements in consumer confidence support such a view. The GfK Consumer Confidence Index rose in September, supported by strong wage growth and easing inflation. The recent descent in mortgage rates from their 15-year high also boosted sentiment, while an upturn in an index tracking households’ desire to make major purchases, bodes well for retail ahead of Christmas. In August retail sales increased by 0.4% after falling by 1.2% in July. Meanwhile, the CHAPS card aggregate spend index rose by 0.5% in September.
But the economy isn’t out of the woods just yet. Consumer confidence is still well below its long-run average, and the BoE’s Agents Survey shows weak retail volume growth for Q3. Households are trading down to less expensive options, while low housing activity is weighing on demand for household goods. And investment intentions remain weak, owing to pressures on cashflow and margins.
Combining the signals from business and consumer surveys, the outlook remains that of near-term resilience but persistent challenges. The consensus forecast is for growth of just 0.4% this year, followed by another 0.6% in 2024.
Change in sales growth among UK businesses
Source: Decision Makers Panel Survey, BoE
Inflation fell more than expected in August
UK consumer price inflation (CPI) fell marginally from 6.8% year-on-year in July to 6.7% in August, but the big news was that core CPI inflation fell from 6.9% to 6.2% – well below the consensus expectation of 6.8%. This was thanks to slowdowns in both services and core goods price inflation. But inflation hasn’t gone away – services CPI inflation, an indicator of underlying domestic price pressures, is still elevated and above the 2000-19 average of 3.3%.
What’s the outlook from here? The headline rate of CPI inflation should continue to fall sharply, with energy’s contribution set to fall too. Household inflation expectations are also on a downwards trajectory and are now back to their long-term average.
Several factors should lead to further easing in services CPI. The recent increase in labour market slack should enable employers to restrict future wage increases, and falling energy costs for businesses should ease price pressures. Businesses are also planning smaller price rises ahead: according to the Decision Maker Panel survey, output prices were expected to rise by 4.4% year-on-year over the next 12 months in August, down from 5.5% in July. According to the latest forecasts from the Bank of England, the headline rate of CPI inflation will fall below 5.0% by the end of the year.
UK inflation and sub components (% change y/y)
The labour market is beginning to cool
The labour market is clearly cooling, with unemployment above the Monetary Policy Committee’s (MPC’s) 4.1% forecast for Q3. Meanwhile, the three-month vacancy-to-unemployed ratio – seen by the BoE as the best indicator of labour-market tightness – was at 0.71 in July, down from a peak of 1.05 in August 2022.
What explains this? Businesses are pulling back on hiring amid rising borrowing costs and tighter budgets, with some considering redundancies. Surveys indicate worse is to come in the months ahead: potential redundancies in the first two weeks of September had more than doubled compared with a year ago.
As yet, there’s been no major impact on the pace of wage growth, with growth in average weekly earnings, excluding bonuses, remaining unchanged at an elevated 7.8% year-on-year. That said, the BoE downplayed the surging wage data in its September meeting, pointing to other wage indicators that show cooling wage pressures. This comes at a time of labour supply picking up, with the workforce expanding by 0.8% year-on-year in Q2.
Overall, rising borrowing costs and shrinking margins is starting to affect the labour market, and it’s likely that slack will continue to increase.
Total pay growth (% change y/y, 3m/3m)
The tightening cycle may nearly be over
After 14 consecutive rate hikes, the BoE surprised the markets at its September meeting by pausing. This suggests borrowing costs have peaked.
The decision was heavily influenced by the lower-than-expected inflation data, but also labour market slack and weak PMIs. That said, the forward guidance was little changed from August: any higher-than-expected inflation readings will result in more hikes. In fact, rates look set to remain high until inflation is clearly heading toward 2% as the Bank did not mention any possibility of rate cuts. The bond market is pricing in a first rate cut for next September.
But the higher-for-longer scenario isn’t a certainty. If the resilience of the UK economy begins to fade, and inflation with it, the BoE will come under pressure to cut rates quickly.
Overnight Index Swap (OIS) forward curve
Source: Bank of England, OIS forward yield curve
(?) what are the numbers on the LHS in graph – are they %?
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