Summary
The UK is the talk of the town, and not in a good way. The coordinated sell off in both gilts and sterling reflect growing concerns about both the health of the economic recovery and the viability of the UK’s policy approach. With monetary and fiscal policy still at loggerheads, the risk of further financial disruption remains acute in the months ahead.
The UK begins in a relatively weak position. The UK is the only G7 economy not to have re-attained its pre-Covid level by the second quarter of 2022. And worse likely remains ahead, with our forecast suggesting that GDP will fall by 0.7% through 2023. The predominant driver of the economic outlook here is the large terms of trade shock. Recent increases in energy prices compound established increases in both food and core goods prices. In each case, this implies price pressures today and crimped incomes tomorrow. We expect that to mean a limited consumer driven recession over the coming quarters, despite additional support.
UK – Spending on Gas and Electricity (% GDP), 2017-2025
Notes: Figures are presented here as a share of quarterly nominal GDP. Spending is conditioned on a Citi VAR model of consumption substitution across sectors, alongside current market futures prices.
Source: ONS, Department for Business and Industrial Strategy, Bloomberg LLP and Citi Research.
For now, a weak demand side sits alongside a supply picture that is also heavily impaired. Here, a reduction in labour supply alongside ubiquitous matching challenges mean the UK labour market remains relatively tight. For the Monetary Policy Committee, the concurrence of a tight labour market and very strong imported inflation mean some action is necessary to reduce the risk of a de-anchoring of inflation expectations. But this will come at a longer-term cost. While a limited supply recovery seems likely, without carefully targeted support, the risk of material long-term economic scarring is growing.
UK – Business Investment (£ 2019 bn), 1965-2027
Notes: Trend business investment growth is based growth between 1965 and 2007.
Source: ONS and Citi Research.
Overall, policy faces a tricky trade-off between risks of a self-propagating recession on the one hand, and a nominal de-anchoring on the other. Sweeping fiscal stimulus is likely only to mean an outsized monetary response and a weaker long-term recovery. At the same time doing nothing is also far from optimal. The core conclusion we draw from recent experience is that policy would fare better by focusing more directly on managing the supply side of the economy. With structural shocks likely to grow more frequent in the decade ahead, that suggests a structural shift in approach.
Key findings
1. The UK can ill afford any more economic policy mistakes. After a lost decade, the government is right to focus on increasing growth. However, it must do so amidst two tightening constraints. The first is institutional credibility. The second is the need to develop appropriate tools to manage increasingly frequent adverse ‘supply-side’ shocks.
2. In the near term, the key challenge facing the UK economy is the terms-of-trade shock – an increase in the price of imports relative to exports. These effects are boosting inflation, but crimping domestic income. We expect these effects to weigh heavily on demand across both the household and corporate sectors over the coming year. The main upside economic risk remains a sweeping reduction in gas prices. Absent this, however, the UK economy is likely to be structurally poorer. The key policy question is how this loss is allocated.
3. For households, the looming cost shock will hit hardest those least able to bear it. Consumption is likely to be weighed down heavily by looming cost increases. The regressive nature of the shock risks exacerbating the near-term economic impact, particularly as consumer credit conditions continue to tighten. We think this should also argue against policies that transfer away from poorer households to their wealthier equivalents. ‘COVID savings’ also seem unlikely to come to the rescue given the mismatch between their accumulation and those suffering the largest real income shocks. In the medium term, sharp increases in mortgage costs may push any consumer recovery into 2024.
4. The weakness on the supply side of the UK economy is now an urgent concern. While output is 2.6% short of its pre-COVID trend, we estimate current excess demand in the order of 1.4% of GDP. Supply should gradually recover in the months ahead as capital and labour gradually reallocate. Targeted support has a key role to play in aiding reconfiguration and boosting incomes, but sweeping fiscal giveaways risk making a bad situation worse. The risk of a greater long-term scarring seems to be increasing.
5. We expect unemployment to increase from here as demand slows, but only gradually. Labour supply should continue to recover as cost-of-living concerns bite and NHS waiting times potentially begin to fall. However, in the near term, labour hoarding effects suggest redundancies are likely to materialise only slowly. Firm insolvencies may prove a key driver of slack in the near term. And in the medium term, unlike with the Great Financial Crisis, we think more persistent labour hoarding effects are likely to prove only limited.
6. Cost pressures remain intense. We expect CPI inflation to peak at 11.8% in the months ahead. While price growth should fall back during 2023, inflation is likely to stay relatively high for a while. And in the interim, the risks of a more nefarious feedback effect into domestic inflation dynamics will remain elevated. For now, we see the risks here as substantial, but contained. However, the sheer level of inflation means uncertainty is particularly high. More monetary tightening is almost certainly needed. De-anchored and expansionary fiscal policy remains the key upside risk to medium-term inflation.
7. The adverse market reaction to the ‘mini-Budget’ was qualitatively different from that to previous events. We think that reflects the now acute conflict between monetary and fiscal policy. In the near term, that calls the UK’s broader institutional credibility into question. In the medium term, it likely means weaker macroeconomic outcomes as the Monetary Policy Committee is forced to ‘overcompensate’ for continued fiscal stimulus. Historically, these shocks have tended to weigh on long-term output as tighter financial conditions weigh on investment.
8. Recent experience shows you cannot effectively manage supply-driven inflation via demand. Policy faces a tricky trade-off steering between the risk of a self-propagating recession on the one hand and the risk of de-anchoring inflation on the other. In our view, a different policy approach is not just desirable, but necessary. The fundamental challenge here stems from the supply-driven nature of the economic shock. Such shocks are likely to occur more frequently than in the past. The current approach risks hampering medium-term growth.
