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A Shallow, Prolonged Downturn Poses U.K. Prime Minister Sunak A Tricky Election Timing Decision

The bad news for Conservative U.K. Prime Minister Rishi Sunak, who has to call a general election at some point in the next 14 months and whose party lost two more hitherto safe seats in parliamentary by-elections this week, is that the IMF predicts that U.K. inflation and interest rates will remain higher for longer than in the United States and the euro-area, and that the U.K. will be the weakest G7 economy in 2024.

The good news is that that is better than the Fund had expected.

Several factors contribute to U.K. core inflation—6.1% year-on-year in September—being slower to fall than in the United States or euro-area:

• As the third largest net food and drink importer and a large net energy importer, the country is particularly vulnerable to volatility in the global economy.

• The job market is tight, and wage growth is high. The U.K. economy has taken longer than its counterparts to recover pre-pandemic labor market participation levels.

• Services have far outperformed manufacturing this year, fueling services inflation and hampering central bank efforts to reduce headline inflation; services account for around 80% of GDP and employment.

• In a recent Office of National Statistics survey, two in five exporters and importers cited Brexit as a costs-raising impediment to trade. Further restrictions on EU-UK trade are expected to enter into force next year.

In addition, Sterling has fallen by 0.7% on a trade-weighted basis since the start of 2022, contributing further to higher U.K. inflation than in peers.

Monetary Policy Response
The Bank of England’s (BoE) policy rate (the “bank rate”) is currently 5,25%. In August, it forecast that bank rate would peak at 6.0% in 2024 and fall to 4.5% by 2026, with inflation slowing to 2.0% by the third quarter of 2025. The IMF sees a slower inflation decline but a similar rates path.

When the BoE updates its forecast next month, it will likely lower its expectations for peak bank rate to 5.5% or less, giving it room to nudge up its 2024 GDP growth forecast. 

However, the strength of services inflation at 6.9% in September (close to May’s peak) and the risk of commodities inflation rising over the winter months means that while the BoE hopes to keep rates on hold for six to nine months, it may have to hike rates further.

Real Economic Activity
The services sector exerts the largest influence on GDP growth, employment and economic policy.

The monthly purchasing managers index (PMI) for services stood at 48.6 in August and 49.3 in September (anything below 50 is a contraction); the services PMI averaged 53.1 between January and June. These data indicate an increased risk of GDP contraction before year’s end.

The relatively robust performance of services compared to the 14 consecutive months of contraction for the manufacturing PMI cushions the slowdown in economic activity and employment but also prevents headline inflation from slowing faster. 

Consumer spending grew 0.1-0.2% year-on-year in the first two quarters of 2023. Scant improvement is likely in the rest of 2023 or the first half of 2024.

This should gradually slow services inflation, but headline inflation will still be well above the BoE’s 2.0% target throughout 2024. 

The consumer spending downturn is likely to be prolonged but also shallow for several reasons:

• real wages returned to growth in July and August;

• consumer confidence has improved but remains pessimistic overall; and

• the ratio of household savings to disposable incomes has fallen from its pandemic peak above 20.0% to 9.5% but remains higher than the 6.5% five-year average to end-2019, suggesting that consumers have disposable income left over from savings acquired during 2020-21.

Business investment held up better than expected in first-half 2023, but higher rates will take an increasing toll. Corporate insolvencies will increase by 16% in 2023 and peak in 2024, according to Allianz Trade.

The British Chamber of Commerce survey of 5,000 firms earlier this month showed that more than half the respondents reported freezing or reducing investment plans.

Mortgage rates have nearly doubled from a year ago, and mortgage approvals and property transactions are falling at a double-digit pace. The BoE expects the monthly mortgage payment of 350,000 households to have risen by at least GBP500 (USD605.9) by the end of 2023.

House prices are retreating steadily from their August 2022 peak. They are expected to fall 8.0-10.0% this year (half the 2007-09 decline) before stabilizing next year.

The labor market is cooling, which will help reduce wage pressures. Job vacancies fell by 43,000 in July-September to 988,000, down more than 20% year-on-year but still nearly 200,000 higher than 2019.

Unemployment increased to 4.3% in July from a low of 3.5% a year earlier. However, 4.3% is still historically low, reflecting a labor market weakening only gradually from a historically very tight level.

While good for consumer spending, wage growth at more than 7.0% is a key concern keeping the BoE from considering rate cuts.

Electoral Implications
Curbing inflation will be the priority ahead of the next general election, likely in the spring or autumn of next year.

As a result, while the baseline scenario is that interest rates will remain on hold, further rate hikes are more likely than rate cuts in the immediate term.

Sunak’s government will unveil what is likely to be its last pre-election budget (for 2024) next month. Any expansionary measures are more likely to focus on welfare spending than tax cuts.

However, in the medium term, economic and financial constraints will place significant pressure on future governments to shift fiscal policy towards austerity rather than further expansion.


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