As the campaign to become the leader of the Conservative party and therefore Prime Minister of the UK is whittled down to the final two candidates, the economy continues to struggle. It has shown paltry growth since the crisis of 2007/8, mainly down to poor productivity. ‘Levelling up’, Brexit, none of these has changed that picture.
Although the economy is not technically in recession this year – defined as two consecutive quarters of negative growth – it can be argued that it feels like one. More and more commentators are forecasting a recession, saying it is only a matter of time before it happens. Indeed, economic growth has been slowing, from 1.3% in Q4 of 2021 to 0.8% in Q1 of this year, and will slow further. But growth this year will average about 3¼% measured in year-on-year terms, reflecting the higher level of GDP since the 2020/21 lows. The point is this growth is not sustainable.
As with many other countries (though not all), UK consumer price inflation has reached 40-year highs, driven partly by energy prices and the mismatch of supply and demand resulting from the end of the pandemic. Energy bills will rise sharply for a second time in October this year. Such an outcome will further reduce real household incomes, cut their spending power, and so hit economic growth. There is further evidence that the pound is weakening, particularly against the euro and US dollar, and this will raise domestic price pressures as the cost of imported materials rises.
Household confidence is low
Hence, it’s no surprise that surveys clearly show that households are struggling, and their confidence has fallen dramatically. The UK’s consumer confidence barometer, produced by GfK, shows the index in July at minus 41, the lowest since the series began in 1974 – and below even pandemic levels. On this basis, it’s perhaps not a surprise that retail sales in volume terms fell by 0.1% in June and were 5.8% lower than in the same period of 2021, see chart 1.
To make matters worse, with the rate of consumer price inflation at 9.2% in June, inflation-adjusted wages – real pay – are declining quickly. On this basis, total compensation, which includes bonuses, is down by 0.9% in the three months to May on an annual basis, and regular pay, which excludes bonuses, is down by 2.4%, the sharpest fall on record.
On the one hand, price inflation has continued to accelerate. That will keep pressure on the central bank to raise interest rates further, possibly by ½%, at the upcoming 4th August meeting, taking the Bank rate to its highest since the cuts post the global financial crisis more than a decade ago.
On the other hand, the pay data suggests that interest rates should not be increased very much. The risk of the economy suffering a deeper recession than necessary is high, with some figures already weakening. For instance, UK money supply growth is slowing and suggests official interest rates could even be cut over the next 12 to 18 months. For now, though, the central bank is likely to maintain a bias to tighten monetary policy, lean against price inflation, and so keep down inflation expectations.
But the economic data are not all bleak
Monthly data on economic activity from the Office for National Statistics (ONS) show the economy expanded by 0.5% in May 2022 after a 0.2% contraction in April, see chart 2. Therefore, depending on the June figure, Q2 may also see some growth in GDP. However, it would be accurate to say that if one goes back to 2018, for example, the UK economy has not precisely been expanding very rapidly on this measure. Since 2018, the economy has grown by 4.1%, equating to an annual increase of just 1.4%.
This includes a period that saw the most significant annual drop in growth since the Second World War. But it also consists of the bounce back from that decline which, as the chart shows, has only just reversed the fall recorded in 2020. Evidence of a recession is unclear from the May GDP data, and the figures showed that all major categories of the economy – services, production and construction contributed to growth. Moreover, monthly economic growth in May was 3.5% higher than in the same period of 2021, albeit down slightly from the 3.5% recorded in April.
This confirmed what we already know about the quarterly distribution of growth for 2022, which is that it will be strong in the first half of 2022 but slow sharply in the second six months, recording an average expansion of over 3% compared with 2021. This is because a big bounce back occurred in quarterly growth in Q1 2021 and is reflected in the output level we are seeing this year.
The UK labour market is holding up remarkably well. Unemployment is low at 3.8% on a claimant count basis, and there are record vacancies – 1.294m from April to June this year, spread across various sectors. The employment rate is also very high at over 75.9 though below pre-pandemic levels. And whilst retail sales may be down in volume terms, it is up in value terms; see chart 1. The latter helps to protect firms’ nominal earnings and ability to pay their staff. Moreover, retail sales may not fall as much as implied by the confidence figures or the volume data as wealthier households accumulated surplus savings during the lockdown when they could not spend. Additionally, with house prices holding up, those with access to equity and capital may not be in a financially weaker position, as is implied by the fall in ‘real’ pay for those dependent on income.
A nuanced picture and a policy dilemma
But this does not mean that all is well with the economy, as some figures noted here demonstrate. The coming 12 months are going to be full of challenges. But it is a nuanced picture, and there are some positives to take away from the current position in which the UK economy finds itself. Even if the Bank of England raises interest rates further in nominal terms as is expected, adjusted for price inflation, real interest rates are deeper in negative territory. This reduces debt’s ‘real’ interest cost and softens the impact on borrowers. Moreover, commodity prices have shown some modest decline recently, with energy prices falling back from recent highs and implying subsiding price inflation in 2023.
Such a challenging economic outlook will require deft management by the monetary and fiscal authorities in the months ahead. Balancing the need to support those hit by the slowdown, yet bearing down on inflation will be a delicate task as economic growth slows sharply or stalls. In addition, addressing the costs of climate change and the need to reduce carbon emissions by pivoting the economy away from reliance on fossil fuels makes the task even harder. These are the key challenges the next Prime Minister will face.