Despite rising inflation and a rapid rise in interest rates, the UK economy has shown more resilience than expected of late. As of November, the Bank of England (BOE) predicted the economy would contract in the second half of 2022 and remain in recession through the first half of 2024.
After contracting in the 3rd quarter of 2022, the UK economy expanded moderately in both the 4th quarter of 2022 and the first quarter of 2023, with business confidence in the core services sector improving sharply and the unemployment rate remaining very low. The economy has benefited from falling energy prices, improving global supply chains and expected global growth.
However, storm clouds are gathering. Despite aggressive monetary tightening, inflation was well above target at 8.7% in May, both in the US and the euro area (Chart 1). Also, core inflation, which excludes food, energy, alcohol and tobacco prices, rose from 6.8% to 7.1% – the highest since March 1992.
The latter is closely followed by policymakers because it better reflects underlying price pressures in the domestic economy, which are driven by wages and firm pricing. With wage growth picking up amid a very tight labor market, core inflation is unlikely to slow significantly anytime soon. Thus, without additional interest rate hikes that weaken the economy, inflation is likely to be above target, and there is a growing risk of a rapid wage-price spiral.
Worried about recent inflation data and rising risks to its credibility, the BOE monetary policy committee moved decisively at its June meeting, raising interest rates by more than expected to 5% – the most since 2008 with seven members voting. In support, the two again made no change in the ratio. The majority argued that the recent strength in wages and services inflation indicates greater stability in the inflationary process.
This is the final meeting of one of the two false opponents, Sylvanas DenRiro, and recent comments suggest that her successor, Megan Green, may be of a more sinister persuasion. The group said it will closely monitor developments and is ready to act again if there is evidence of persistent inflation. Financial markets expect rates to peak around 6%. The balance of risks points clearly in the direction of further policy tightening, and rates remain elevated for a longer period of time.
Monetary policy operates with a lag of up to two years, and the cumulative effects of current and past tightening are increasingly weighing on the UK economy and housing market. Only about 15% of mortgage holders are on variable rates, while the rest typically have their rates fixed for two years or five years.
According to ONS calculations, more than 1.5 million mortgages are due to be refinanced by the end of 3Q 2024, of which 40% and almost 50% had initial fixed mortgage rates of less than 2% and between 2-2.5% respectively (Chart 2 ) and these mortgages will need to be refinanced at a dramatically higher rate. .
Estimates from the Resolution Foundation show that the average mortgage re-setter will be £2,900 worse off by 2024, which will hit household consumption hard. The risk of rising mortgage defaults will also increase, although if banks agree to work with struggling homeowners, a huge vicious cycle of forced sales may be avoided, even if there is no big increase in the unemployment rate.
Businesses are also feeling the pain of rising prices and tighter monetary policy. Interest rates on loans have risen sharply, and corporate bankruptcies in 2023 are running 10% higher than 12 months ago.
Prime Minister Rishi Sunak’s re-election in 2024 will be a difficult economic backdrop. The government appears to have ruled out direct financial assistance to struggling mortgage borrowers for fear of exacerbating inflationary pressures. Rising borrowing costs on government debt significantly reduce its room for maneuver, including cutting taxes next year.
Ultimately, the key for the UK economy is structural reforms that increase its capacity for growth without creating inflationary pressures. Such policies usually take time to bear fruit, and some will undoubtedly be unpopular with the government’s supporters.
All in all, it looks like an increasingly difficult backdrop for the UK economy in the coming quarters, with risks of a recession rising sharply. It is important for accountants to warn their companies and clients about various risks. Meanwhile, we will be closely examining the results of the upcoming quarterly Global Economic Conditions survey of accountants and CFOs for signs of pressures on the UK and global economies.