Economy in brief: July 2023

Economic growth remains resilient, but underwhelming

Recent data has painted a familiar picture of the UK economy: resilient (but tepid) growth, high (but falling) inflation and a tight (but loosening) labour market.

Latest GDP data showed that the economy contracted slightly in May (-0.1%), which was widely expected given the extra bank holiday for the King’s coronation. In underlying terms, activity has been broadly flat since mid-2022 – which has nonetheless surpassed earlier forecasts of a recession this year by most economists (including us).
Weak activity reflects headwinds from high inflation and widespread supply-side disruption: previously from global supply chain pressure, and more recently from labour shortages and strikes across the public sector.

Inflation is falling, but domestic price pressures remain persistent

These headwinds have started to recede. CPI inflation fell to 7.9% in June, its lowest in fifteen months. The decline was larger than most analysts expected (a fall to 8.2% was projected), after a run of a few months where inflation had surprised to the upside.

But one swallow doesn’t make a summer. Even after the latest fall, inflation in the UK remains the highest in the G7. Measures of more domestically-generated price pressures remain stubbornly high: both core and services inflation also eased in June (to 6.9% and 7.2% respectively) but to a much lesser extent than the headline CPI rate.

This will concern the Bank of England, who are worried that the persistence of domestic price pressures is a sign that previously high inflation is becoming embedded in price and wage setting. Indeed, pay growth also remains sticky: excluding bonuses, annual growth was at a multi-decade high of 7.3% in the three months to May.

Further rate rises will tighten the screw on mortgage payments

Taken together, this means that it’s not a question of “if” the Bank of England will raise interest rates again in August, but by “how much”. Up until now, most analysts expected another hefty hike in rates (of 50 basis points, bringing Bank rate to 5.5%). But the latest fall in inflation, accompanied by a nascent loosening in the labour market – with vacancies falling, unemployment edging up, and inactivity declining – may take some of the pressure off the Bank. So a smaller rate rise (of 25 bp) is now back on the table.

But this doesn’t change the bigger picture, which is still one of more monetary tightening ahead. Financial markets are expecting Bank rate to peak just below 6% in early 2024 – though market expectations are very reactive to economic data flow and developments.

It’s widely documented by now that a larger number of households will be rolling off fixed mortgage contracts this year, and so will be feeling the pinch of higher rates for the first time. As yet, the macroeconomic impact of this is unclear – the hit to household incomes may be at least partially offset by further falls in inflation, and a tight labour market. But either way, it looks like tighter financial conditions are here to stay for the time being.