This piece first appeared on Conservative Home – 10th January 2023
The good, the bad and the uncertain is how I describe this year’s likely economic outlook. The good is that inflation is likely to fall significantly. The bad is that growth will be weak, with the economy in recession during the first half of the year; a continuation of the weakness we are already seeing. The uncertain is where inflation will settle, where interest rates will peak and how resilient or vulnerable employment and the property market will prove to be.
The economy could recover in the second half of the year if a deceleration in inflation allows a recovery in real incomes and consumption. But much will also depend on how firms react to an environment of higher costs and taxes plus tough credit and lending conditions, and whether they cut jobs and defer investment plans.
Avoiding a self-feeding downward cycle is critical, with the outlook impacted by the economic fundamentals, policy and confidence. Business and consumer confidence is weak and there is little room for policy manoeuvre. Political uncertainty hasn’t helped, but Rishi Sunak’s government has provided stability and that may help with business confidence.
While the Government has provided significant timely and targeted help to contend with the energy crisis, the cost-of-living crisis has been fed by the persistence of inflation. This has continued to outstrip wage growth, with latest data showing average wages, excluding bonuses, rising by 6.1 per cent in the three months to October.
Inflation reached 10.7 per cent in November, having peaked at 11.1 per cent in October. Energy prices naturally will impact the inflation outlook, and while geopolitics, and the war in Ukraine mean that the outlook is uncertain.
The latest signs are that these pressures are easing significantly. Oil prices are way off their highs, and gas prices have fallen. Yet inflation was already at 6.2 per cent and rising when Russia invaded Ukraine last February, and the two key factors that have fed inflation in recent years are now being reversed. These are the supply-side factors that triggered bottlenecks and higher global transport costs, and previously lax monetary policy.
Thus, inflation could halve this year and could decelerate further in the first half of 2024. The uncertainty over inflation relates to what happens to wages, to inflation expectations and the extent to which firms pass on higher costs, and how policy responds.
In December the Bank of England hiked interest rates from 3 per cent to 3.5 per cent. In my view, the Bank does not need to raise rates further, as the economy is slowing, inflation has peaked, previous rate hikes are still feeding through and further tightening through a reversal of quantitative easing has already been announced. But it still appears that the Bank has a bias to push rates higher, perhaps to prove it is tough having been slow to see the inflation problem.
As inflation decelerates this should allow some recovery in spending power and consumption towards year-end. However, the immediate outlook remains tough. The economy is already on the verge of recession.
A technical recession is two successive quarters of negative growth. Based on the latest data, in the three months to October the economy contracted 0.3 per cent from the previous three months. GDP rose 0.5 per cent in October after a 0.6 per cent fall in September, distorted by bank holidays linked to the passing of the Queen. The imminent release of GDP data for November is expected to show a monthly decline.
Within these figures, the picture varies. Manufacturing is on a clear downward trend. Construction, by contrast, appears in good shape, with the Office for National Statistics (ONS) reporting October as the highest level of construction output since records began in July 2010. We may not be building enough new homes, but there is considerable activity, benefiting many trades. The UK though is largely a service sector economy. ONS data shows consumer facing services still 8.9 per cent below their pre-covid peak, while other services are 2.4 per cent above.
More recent data, closely watched by financial markets, confirms the economy’s weakness, although it is perhaps not as weak as previously feared. The manufacturing purchasing managers’ index, a measure of activity, was at a 31-month low of 45.3 in December, where 50 represents the threshold between growth and contraction. In contrast, though, the services measure was 49.9, suggesting stabilisation.
While there is much talk of a deep recession, the jobs data suggests it may be shallower and shorter-lived than some fear. Latest figures released mid-December showed employment reaching an all-time high of 36.2 million in September. Over the previous three months, employment had risen, despite a decline in those in self-employment. While the number of vacancies has declined recently, this is at a very high level of close to 1.2 million in November. This has already led to much focus on those who have left the labour force during the pandemic, particularly over 50s and 18-24 year-olds. Staff shortages are proving to be a common post-pandemic problem across many countries.
In addition to this cyclical picture, one can judge an economy’s performance in structural and relative terms. In structural terms – even if we have a shallower recession – the message is the need for a pro-growth economic strategy, something we have argued for here, many times before.
What about in relative terms? The world economy rebounded strongly post-pandemic but has weakened significantly over the last year. According to the International Monetary Fund (IMF), after growing six per cent in 2021 the global economy grew 3.2 per cent in 2022 and will grow 2.7 per cent this year. A global growth rate around three per cent is considered weak and this year the IMF believes one-third of countries will be in recession.
After contracting the most among the G7 in 2020 the UK then grew the strongest in 2021. There needs to be care in making international comparisons in the immediate wake of the pandemic, given the way different parts of the public sector – such as health and education – are measured across countries. But compared with pre-pandemic, the US has rebounded 4.4 per cent, France 1.1 per cent and Germany 0.3 per cent while the UK is still 0.8 per cent below.
The IMF expects the U.K. to grow just 0.3 per cent this year compared with 0.7 per cent for France while Italy (-0.2%) and Germany (-0.3 per cent) contract. By contrast, the OECD expects the U.K. to be weaker this year, contracting 0.4 per cent, versus -0.3 per cent in Germany while Italy (0.2 per cent) and France (0.6 per cent) grow.
While these small differences in forecasts have been used to construct alarming headlines about the U.K.’s relative performance, the reality is that all the major economies in Western Europe face a challenging time, as they contend with recession and the contagion from war in Ukraine – and looking further ahead, the need is for Western Europe to reposition itself in a changing and growing global economy. As pointed out in a recent detailed report edited by Graham Gudgin it would be wrong to blame the UK’s current economic weakness on Brexit – something I will return to in a forthcoming column.
Last week, the Prime Minister outlined five measures against which his government should be judged. In qualitative terms, it was hard to disagree with the five aims: halving inflation, returning to economic growth, reducing debt plus reducing waiting lists and addressing cross channel migration. However, in terms of the three economic yardsticks, in quantitative terms, while they may have been far from stretching they are likely to be met.