Macro - UK

UK economy: Foxtrot instead of Boogie Woogie

06 March 2023

Michel Vernier, CFA, London UK, Head of Fixed Income Strategy

Key Points

  • The UK economy is showing signs that it’s in better health than was expected only a few months ago. That said, the country is still bearing the brunt of a cost-of-living squeeze – with inflation running higher than most other leading economies
  • While at a multi-decade high, inflation is edging lower at last. In addition, the economy has avoided a recession, so far. But it seems too early to get carried away
  • The Bank of England also remains laser-focused on bringing inflation back down to its 2% target, despite the surprisingly tight job market
  • Regardless of the fragile nature of the economy, more interest rate rises are still forecast as we head further into 2023, with the Bank of England saying a “tighten-stop-loosen policy boogie” of halting, then restarting, interest rate rises would be a mistake

Recent UK economic data seem to have provided some reasons to be more more cheerful. But as the Bank of England has pointed out, smaller policy steps may not result in a light-footed “Boogie Woogie” strategy.

Recession postponed

UK economic data seems to have provided more optimism of late, not least for the Bank of England (BoE). While UK gross domestic product (GDP) declined by 0.5% in December1, growth in the fourth quarter was flat, and not negative as widely feared.

A technical recession (two consecutive quarters of falling output) was averted due to a rebound in the quarter, following the additional holiday due to the Queen’s funeral in September. The latest data confirm growth of 4% in 2022. Still, the overall economic output is 0.5% below its pre-pandemic level. Despite averting a recession on this occasion, the risk of further periods of contraction remains. 

Fragile growth foundations

The UK consumer, in the midst of a cost-of-living squeeze not seen for many decades, remains vulnerable. Despite a small technical rebound in January, year-by-year retail sales were down 5.6% year-on-year, reflecting the precarious state of affairs.

Meanwhile, domestic industry is sending mixed signals. The manufacturing purchasing managers’ indices (PMI) are in contractionary territory, while the PMI for services has rebounded into expansionary territory. So, while recent upbeat economic data may be welcome, the possibility of weaker UK growth remains high. A decline in GDP by 0.5% seems likely this year over 2022.

For now, the biggest threat to the outlook remains inflation. Recent monthly data hint that the worst may be over (see chart). UK headline inflation, as measured by the consumer prices index, moderated to 10.1% in January from 10.5% in December.

Meanwhile, core inflation, excluding energy and food costs, retreated to 5.8% year-on-year from 6.3% in December, a trend the BoE may be particularly pleased about. Still, at 10.1%, inflation remains very high by historical standards, or in comparison to the eurozone or the US.

Tight job market is a concern

The job market remains a key factor in the outlook for inflation in services. The UK market remains tight, and tighter than in many other developed economies. While total wage growth may have eased in December, driven by base effects, regular pay growth (without bonuses) rose to 6.7% (based on the average for the previous three months, on a year-by-year basis)2.

Annual pay growth in the private sector is steaming ahead, at 7.3%, and is at an all-time high, ignoring recent distortions to the figures caused by the pandemic. This trend, along with the rise in public sector wages (4.5%) and potential for strikes in the sector to push wage hikes higher still, is what the BoE may be most concerned about at this point.

With a significantly smaller pool of workers since the pandemic and an unemployment rate at 3.7% (see chart), job vacancies are still far above the range seen over the last 20 years.

Some way to go

During the last Monetary Policy Committee (MPC) meeting  the BoE emphasised that it will act more on the basis of incoming data. However, it is still too early, in our view, to say that inflation at 10.1% has been vanquished. After all, the pace of price rises remains a long way from the BoE’s 2% target. BoE member Catherine Mann pointed out in a recent speech: “The consequences of under tightening far outweigh, in my opinion, the alternative.”

For now, the BoE is likely to focus on inflation. But the economy’s vulnerabilities, not least from a sharp consolidation in the domestic housing market as mortgage-holders cope with higher rates, mean that the central bank may need to hike rates in smaller steps and tread carefully.

The central bank will probably make at least one more hike (if not two) this year. The market prices in a peak in the base rate at around 4.5% in September. Mann prefers a more determined and decisive path in the BoE’s rate-hiking dance: “A tighten-stop-tighten-loosen policy boogie looks too much like fine-tuning to be good monetary policy,” she said3.

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