The UK has bounced back vigorously from the worst of the coronavirus-induced recession. However, global supply-chain constraints and Brexit-related shortages have forced the central bank to act already, putting the UK at risk of another slowdown.
The UK economy has enjoyed a far stronger recovery than was initially envisaged at the start of the 2021. The successful vaccination programme, relatively early reopening of the economy, robust household consumption and bigger-than-expected fiscal package have all contributed to the bounce back from the depths of the recession. However, the backdrop for 2022 will be more challenging due to the supply chain/Brexit disruption, elevated inflation and higher taxes/interest rates.
UK output has edged back towards pre-pandemic levels over the past few months. In August, gross domestic product (GDP) was just 0.8% shy of that achieved in February 2020. The final lifting of restrictions, in the middle of July, paved the way for the recovery in consumer-facing services. Hospitality, leisure and retail are close to pre-crisis levels, although travel and transportation have continued to lag behind.
The recovery in business confidence has failed to keep pace with consumers. While business investment was 12.8% higher in second quarter (Q2) than the year earlier, it is still significantly below where it was in Q4 2019.
On the positive side, the UK labour market continued to improve in Q3. The number of employees on payrolls in September hit a record 29.2 million, thereby surpassing the February 2020 levels for the first time in the pandemic. According to the Office for National Statistics, in the three months to August, unemployment fell to 4.5%, although this figure does mask the fact that more than a million people were still participating in the job retention scheme.
Supply has been returning to the workforce with falling numbers of inactive people, albeit the decline has slowed, leaving an excess of around half a million relative to pre- pandemic levels.
Headline wage growth for the three months to August was 7.2%, although when taking into account base and compositional effects, the Office for National Statistics (ONS) estimates a rather wide range for underlying pay growth of 4.1-5.6%.
Outlook for the workforce more stable
The outlook for the UK labour market is certainly more stable than it appeared at the start of the year. At the height of the pandemic, economists feared that UK unemployment could surge to around 9%. Even with the ending of the furlough scheme, unemployment is unlikely to swell due to the record number of job vacancies (1.1 million) advertised in the Q3, although there are concerns around the mismatching of skills.
We estimate that the unemployment rate will creep up into year end, finishing at 5.6%. For 2022 and 2023, we expect that the UK labour market will gradually improve, unemployment averaging 5.4% (see figure 1) and 5.1% respectively.
After a strong start to the year, retail sales have lost momentum over the summer months, although in August they were 4.6% higher than their pre-coronavirus levels. The recent weakness may be attributed to a combination of global/Brexit supply-chain pressures, rising prices and the switching of consumption to services from goods.
Across the retail industry, almost 20% of businesses recently reported that they were unable to get the materials, goods or services needed from within the UK in the last two weeks, according to the ONS. In addition, a number of retailers reported that a lack of staff has been infringing upon their ability to trade. While department stores have registered some of the biggest declines, online retailers are continuing to thrive. In August, the proportion of online sales increased to 27.7% of all purchases, up from 19.7% in February 2020.
However, inflationary pressures on disposable incomes, higher taxes and the impact of interest hikes might all dampen [consumer] demand
In 2022, household consumption will battle against opposing forces. Pent-up demand, high levels of savings, and the resilient labour market suggest that consumer spending is likely to remain elevated next year. However, inflationary pressures on disposable incomes, higher taxes and the impact of interest hikes might all dampen demand.
The impact of Brexit has been somewhat overshadowed by the global health crisis, but has clearly been exacerbating some of the supply-side constraints. The sourcing of materials, labour and even energy have proved to be tangibly harder to deliver, due to extra friction created by the decision to leave the European Union. We assume that Brexit-related disruption will act as 0.5 percentage point (pp) drag on annual GDP as the economy adjusts to the new trading conditions.
The UK government has laid out extensive plans to increase corporate, dividend and national insurance taxes over the next few years. In the biggest revenue raising exercise since the 1970s, the tax hikes equate to more than 1.6% of national income.
In April 2022, the new Health and Social Care levy will come into effect and the additional 1.25pp will be paid by both employers and employees. Initially, the levy will be added to national insurance, but from April 2023 it will become a separate tax. It is estimated that it will raise £12 billion per annum and will be ring-fenced for health and social care costs.
Alongside the corporation tax rise to 25% from 19% as at April 2023, investors and business owners will also be affected by a 1.25pp increase on all dividend rates. While the higher taxes will help facilitate the investment required by the overburdened health and social care system, these measures are unlikely to support short-term growth prospects.
September’s inflation print demonstrated continuing price pressures, with the headline consumer price index (CPI) rising 3.1% year on year. The latest figures do not include the spike from petrol prices, or the regulator’s 12% energy price cap increase that came into effect in October, which looks set to add an additional 0.4 percentage points to inflation. We expect many retailers will try to pass on higher input costs to consumers, and anticipate food and clothing inflation will rise in 2022.
Taking these changes [expected increase in energy prices] into account, we estimate that CPI will average 3.1% next year and 1.9% in 2023
The prospect of a prolonged gas squeeze suggests that further increases in the energy cap will be on the cards next year, before declining in 2023. The increase in the energy component alone leads us to project that headline CPI will peak at 4.7% in April, before decelerating back to 1.6% in April 2023.
Taking these changes into account, we estimate that CPI will average 3.6% next year and 2% in 2023. The upside risk to these forecasts is likely to emerge from supply shortages in the labour market, specifically driven by the end of economic migration from the EU.
The acceleration in inflation expectations is most likely enough to convince the Bank of England’s Monetary Policy Committee (MPC) to raise interest rates in order to maintain credibility. We therefore believe that a near-term hike is highly likely.
In all probability, the hiking cycle looks set to begin with a 15 basis point (bp) increase at the December MPC meeting. This could be followed by up to two hikes in the first half of next year. A lot will depend on the incoming data on the job market, as well as on inflation. At this point, we don’t think the base rate will go as high as 1% in the next 12 months. Instead, the BOE may try to maintain a lower base rate level for some time after the first hikes.
That being said, given the broad-based risks to the recovery and the wide range of headwinds facing the economy, it’s also conceivable that any hike may have to be reversed in 2023.