Chief Economist’s Weekly Briefing – Cloudy

The UK economy continued its robust recovery from the pandemic and tax revenues remained strong. However, good news on the public purse have been matched with challenging news for household finances as cost-of-living crisis unfolds. The chancellor announced some support measures with cuts to national insurance and fuel duty, but this won’t offset the projected drop in standards of living.

5,6,7,8. No it is not the 1990s hit by Steps but the trajectory of UK inflation. February saw the annual rate of CPI hit 6.2%, up from 5.5% the previous month —the highest since March 1992. Back then Shakespears Sister was topping the charts with ‘Stay’. CPI will not stay in the 6’s for long with April’s figure set to exceed 7%. Meanwhile the Office for Budget responsibility (OBR) projects a 8.7% peak in inflation in Q4-22 – 4.3 ppt higher and two quarters later than the October forecast, and even above the Bank of England’s 8% estimate. Consumer goods prices (as opposed to services) are already in the 8’s with February’s reading of 8.3% at a record high (series began in 1989). Energy price rises may be grabbing most of the headlines for now but watch out for food in the months ahead.

Downgrading much. Higher inflation will likely outpace income growth which, when combined with tax rises, will result in a real living standard squeeze of 2.2% in fiscal year 2022-23 according to the OBR – the biggest fall in UK living standards in any single financial year since ONS records began in 1956-57. What’s worse, households’ real incomes are not likely to return to their pre-pandemic levels until 2024-25. That’ll sap growth. GDP is now expected to rise 3.8% this year, down from the 6% estimate back in October. The better news is that business investment (although downgraded) is expected to grow at a healthy 10% clip this year.  

Scarring. Growth is forecasted to slow further in 2023-24 as the cost-of-living squeeze continues, some fiscal support is withdrawn, and monetary policy tightens further. The OBR forecasts UK growth of 3.8% growth in 2022 – down from an earlier 6%. At least the anticipated permanent damage to the economy, at 2%, remains unchanged. What has changed is the higher contribution of lower labour supply to scarring, which is offset by lower contribution from weaker productivity growth.

Benefit & disbenefit. Public sector net borrowing excl. public sector banks (PSBs) came in £13bn in February, much higher than both the consensus and OBR’s October Budget forecast of £8bn. No prizes for guessing what drove this! The markedly higher inflation trajectory has boosted interest payments on index-linked debt. And, to add to this, government spending on goods and services has been higher than expected, in part driven by the unanticipated surge in Covid-related spending linked to Omicron. But inflation has been a give some, take some story when it comes to public finances. VAT receipts were stronger than expected, having benefited from higher prices. Piecing it together, OBR’s latest forecast expects the need for borrowing to more than half from its post-World War II high of 15.0% of GDP in 2020-21 to 5.4% in 2021-22.

Strong start. UK housing market still hot at the start of year despite the disruption caused by Omicron. Annual house price growth was 9.6% in January—down slightly from a revised 10% figure for December—and well above its 3.6% average rate in the 2010s. Race for space continued to be priority for households and prices for detached homes increased by 12.6% y/y in January, whereas flat prices rose by just 5.1%. In the meantime, cost of living crisis has a housing flavour as well, private rental prices have risen by 2.3% in the year to February, the highest annual growth rate since 2016. Question remains whether this strong start will be sustained further, however seem less likely given the outlook for real incomes and higher mortgage rates.

Strength in the face of adversity. The UK Composite PMI for March edged down to 59.7 from a historical high of 59.9 in February. Having said that, the PMI surveys indicated a sustained robust pace of expansion in March as the further reopening of the economy from Covid-19 containment measures helped offset headwinds from Russia’s invasion of Ukraine, Brexit and rising prices. The Manufacturing PMI slumped to 55.5 in March from 58 in February, missing the market expectation of 56.7. The Services PMI was the silver lining as it jumped to 61 from 60.5, overshooting market expectations of 58. Nonetheless, there are concerns about the outlook following the impact of war in Ukraine and the intensifying squeeze on real households’ incomes. Businesses showed increasing concerns at the likelihood of “stagflation” — combination of slow growth and high inflation— in the months ahead.

Losing momentum. UK’s recovery from the Covid-19 has not been smooth, owing to the escalating price pressures and plummeting business and consumer confidence following the war in Ukraine. Inflation squeezing household finances is on and had a direct negative effect on February’s retail sales figures. They have fallen by 0.3% m/m in volume terms following a 1.9% rise in the previous month and were 1% below their average level in the second half of 2021. Stormy weather in February and consumers going out rather than spending on grocery shopping didn’t help either. The downward trend will remain in the near term as households experience the effects of soaring living costs with 30-year high levels of inflation, higher taxes, and rising interest rates.

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