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The recent burst of inflation in the US and in many other countries has led investors to wonder whether the entire inflation environment has changed.
The Bank of England recently updated its growth projections in its May monetary policy report, forecasting a contraction in GDP in 2023. In this Macro Flash Note, Sam Jochim looks at the uncertainty surrounding these projections and the main headwinds facing the UK economy.
UK GDP expanded 0.8% quarter-on-quarter in Q1 according to data published by the Office for National Statistics (ONS).1 This represents relatively strong growth and could be associated with a healthy economy if taken at face value. However, when looking at the monthly estimates of GDP provided by the ONS, there is evidence of a slowdown in activity over the quarter with GDP falling by 0.1% month-on-month in March.
In output terms, first quarter growth was driven by an increase in services, which was also the case for the final quarter of 2021 (see Figure 1). These increases matched higher demand for spending on restaurants and hotels, as measured by the expenditure approach to calculating GDP.
Source: ONS and EFGAM calculations.
Since services play an important role in the UK economy, it is notable that the Bank of England (BoE) forecasts a slowdown in demand due to the squeeze in real disposable incomes resulting from high inflation.2 The BoE projects CPI inflation to peak at 10.2% year-on-year in Q4 2022 (see Figure 2). This would be later than in the US where the peak may have already occurred. The reason for this is the expected increase in household energy prices in October due to Ofgem price cap increases.3 4 The BoE expects this to be compounded by higher tradeable goods prices, a corollary from lockdowns in China.
Source: BoE and EFGAM calculations.
As real incomes decline, the aggregate savings accumulated by households during the pandemic should support their ability to smooth consumption according to the BoE. Whether this materialises remains to be seen and represents a downside risk to the BoE forecast.
In response to rising inflation, the BoE has raised Bank Rate four times since December 2021. The May monetary policy report signalled that further rate hikes will be needed in the coming months. The impact of these rate increases remains to be seen. While they will slow the economy, the expected decline in inflation in the following years would increase real disposable incomes if wage growth were unaffected. This could provide a boost to growth. As such, there is much uncertainty in the BoE projections for UK growth (see Figure 3) over the coming years.
Source: BoE and EFGAM calculations.
The BoE is currently projecting a sharp slowdown in growth. The BoE anticipates that GDP will decline by 0.25% in 2023, followed by 0.25% growth in 2024. It is important to note these projections are unusually uncertain. A wide range of factors will influence the economic outcome, including the degree of monetary tightening that will be adopted to rein in inflation. The BoE projections are based on the path of Bank Rate implied in forward markets which, as at the time of the BoE’s forecasting exercise believed it will rise to 2.5% at the end of 2023. If Bank Rate were to rise more than this, the growth projection would be further downgraded.
Furthermore, it is extremely difficult to predict how the zero-Covid policy adopted in China will impact the global economy, but the longer it stays in place the higher the risks are to growth. The same is true of the war in Ukraine due to the high degree of uncertainty regarding its duration and outcome, and of the resulting commodity price volatility adding to the headwinds to global growth.
From Q1 2023 onwards, the BoE projects year-on-year growth to moderate to between -0.8% and 0.5%. Given the high levels of uncertainty surrounding the outlook, the risks are large and appear to be skewed to the downside. While the BoE makes no mention of a recession in its May monetary policy report, the UK economy faces significant risks over the next 12-18 months and the BoE itself projects that UK GDP will be moderately lower in 2023 than this year.
1 https://www.ons.gov.uk/economy/grossdomesticproductgdp/bulletins/gdpfirstquarterlyestimateuk/latest
2 https://www.bankofengland.co.uk/-/media/boe/files/monetary-policy-report/2022/may/monetary-policy-report-may-2022.pdf
3 3 Ofgem regulates energy for the UK and limits the rate that energy suppliers can charge using a price cap which is updated every April and October
4 https://www.ofgem.gov.uk/publications/price-cap-increase-ps693-april#:~:text=Related%20links&text=The%20energy%20price%20cap%20will,%C2%A31%2C309%20to%20%C2%A32%2C017
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