As the temperature rises and attention turns towards holidays, what is the latest picture for the UK economy? Our Deputy Director for Macroeconomic Modelling and Forecasting, Professor Stephen Millard, spoke to Associate Economists Paula Bejarano Carbo and Hailey Low to get their thoughts.
As the Bank of England (and NIESR for that matter) move into their Quarterly Forecast Round, what are the key issues for the UK economy that they need to think hardest about?
HL: The UK economy is under pressure from a number of complex and interconnected issues. These challenges, which include inflation, the ongoing war in Ukraine, and stagnation in living standards, inter alia, have coalesced into a fragile economy which policymakers are finding extremely difficult to manage. The Bank Rate is now at its highest level since 2008, and the MPC has signalled that there could be further rate hikes to come given the persistence of inflation. This all raises a number of key issues that should be considered as we think about the outlook for the UK economy.
Firstly, the MPC needs to strike a balance between their fight against inflation and raising rates too high as doing so might trigger a recession. It will take time for the full impact of the 13 consecutive increases in interest rates to be felt by consumers, given both the delays in the pass-through of changes to the policy rate into other interest rates and the cumulative nature of the change in rates. The economy has seen a cost-of-living crisis and has now been struck by the increased cost of borrowing. Higher rates mean that bad debts are expected to increase amidst the economic downturn as consumers and businesses struggle to repay loans at higher rates. This has negative implications for banks as risks to capital returns and asset quality intensify. Risks to the housing sector are also possible, as higher mortgage rates could mean seeing mortgagers having difficulties in housing repayments.
Secondly, as the NHS celebrates its 75th anniversary, the government needs to increase investment in the NHS so as to enable access to timely and proper healthcare. I cannot emphasise this enough as the labour market is suffering from a severe labour shortage and long-term sick are driving the high economic inactivity rate. Enabling this large group of people to return to the workforce would alleviate some pressure in the hot labour market, a point NIESR made in our Spring Budget Response.
CPI Inflation failed to fall in May, remaining at 8.7 per cent. What is driving this high inflation? What are we expecting inflation to be in June and over the next few months?
PBC: The annual rate of CPI inflation in May largely reflects energy price decreases being offset by price increases in both food as well as services such as travel, and recreational and cultural goods and services. This latest figure of 8.7 per cent represents a positive surprise in that many expected energy price decreases to drive a significant decrease in inflation in the second quarter of 2023. What we’ve seen, however, is that price rises in food (which makes up around 10 per cent of the consumer expenditure basket which the CPI inflation rate is based on) and services have contributed heavily to keeping the CPI inflation rate elevated.
The annual rate of food inflation was 18.3 per cent in May. This elevated figure is partly a consequence of Russia’s invasion of Ukraine, since Ukraine is a big exporter of essential food like sunflower oil and wheat. For example, in May, the annual rate of inflation for flours and cereals was 23.6 per cent, whereas prior to the invasion (January 2021), the inflation rate for this sub-category was -3.3 per cent. At the same time, survey data, such as the S&P Global/CIPS UK Services Purchasing Manager’s Index tell us that price rises in the services sector partially reflect businesses passing on rising input costs like increased wages and still-high energy prices onto customers.
Looking at measures of underlying inflation can give us an idea of the nature of current inflation and where it may be headed. Core inflation rose to 7.1 per cent in May, its highest rate since March 1992. This measure indicates that, as a result of the original shock to energy and food prices caused by the Russian invasion of Ukraine, inflationary pressures have permeated indirectly (sometimes referred to as ‘second round inflation effects’) to other areas of the economy, such as services via increased input costs (like wages). At the same time, NIESR’s measure of underlying inflation, which excludes 5 per cent of the highest and lowest price changes, fell to 9.9 per cent from 10.2 per cent in April. Trimmed-mean inflation being higher than headline inflation indicates that the energy price fall which has driven headline CPI down is a rather volatile price movement.
Taken together, the latest data suggest that, though inflation will fall gradually over the coming months, this may be slower than expected and we can expect inflation to exhibit persistence in the third quarter of 2023.
The Bank of England recently raised rates to 5 per cent. Should we be bracing for further increases and where do we see interest rates heading over the medium term?
PBC: Against a backdrop of 8.7 per cent inflation, the MPC opted to raise interest rates at its June meeting. The MPC now expects that, given the available data, this interest rate level is sufficiently high to bring inflation back to its target rate of 2 per cent.
That said, as I mentioned earlier, the data indicate that inflation may continue to be stubbornly high in the coming months. Thus, it is possible that the next CPI data release contains another positive surprise. If that is the case, the MPC might deem it necessary to raise interest rates further to return to an inflation path that gets us back target in the medium term.
But, it’s not all about the CPI data. Interest rates at 5 per cent are quite high, and the effects of this on the economy (like households having to cut spending in order to afford elevated mortgage repayments) are definitely being felt and will continue to be felt over the coming months. With the consequences of higher borrowing rates being passed on slowly throughout the economy, it’s true that the MPC has already done much of the ‘heavy lifting’ needed to bring inflation back down. In fact, two members of the MPC felt that no further rate rises were needed at its June meeting.
So, while it’s possible that there may be one or two more rate rises as a result of CPI data surprises, interest rates are probably close to peak. So, over the coming months, we can expect the MPC to reach a peak interest rate and to hold it there for some time until it deems that the economy is ready for it to begin unwinding interest rates.
A key issue for a long while has been the fall in labour supply. Where is the UK labour market currently in terms of employment, unemployment and vacancies, participation, and wage growth and where do you see it going?
HL: The current state of the labour market: febrile and tight. Since NIESR published our Spring Outlook, the employment rate increased by 0.2 per cent to 76 per cent while the unemployment rate remained unchanged 3.8 per cent. It is notable that both indicators are still below the pre-pandemic rate.
However, there is some evidence the labour market is on the turn as vacancies fell by 0.05 million to 1.05 million suggesting that global economic uncertainty is still impacting businesses and firms are adjusting their hiring plans in response to weaker activity. The economic inactivity rate also decreased by 0.1 percentage point but remained 0.7 percentage points above its pre-pandemic level. The long-term sick remain the largest group within the inactive population and the number of long-term sick has reached its highest level since the start of the pandemic – this is a serious cause for concern amidst the hot labour market.
This shrunken workforce will lead to increased competition for staff and thus continue to drive rapid wage growth (especially in the private sector), which shows little signs of slackening, and this could keep price pressures elevated for some time. With near record-low unemployment, more than a million job vacancies and wage growth of 7.2 per cent – we expect that the job market will remain tight for a long period.
