H2 2023 outlook for the United Kingdom

By Stuart Cole | @Stuart Cole | 21 September 2023


The outlook for the UK has improved considerably over the course of 2023, to the extent that we now expect the UK to avoid a recession and for the Bank of England (BoE) to manage a ‘soft’ landing for the economy as it slows activity sufficiently to bring CPI back to target. Consequently, in the absence of any further significant external shocks, we now see the current level of interest rates (5.25%) consistent with the terminal rate, although the BoE will commit publicly to being willing to raise rates further if inflationary pressures show renewed signs of strengthening.

Elsewhere, despite enduring the highest level of inflation in the developed world, inflationary pressures are finally starting to ease and appear to be on a sustainable downwards path. The key policy consideration now is one of the speed of reduction rather than direction. In a similar vein, the labour market is finally starting to show signs of weakening, although the strength of wages growth continues to be the bugbear and will ensure that monetary policy retains its tight bias.

  • Despite the less pessimistic growth outlook, economic activity will remain sluggish over the remainder of the year and growth for 2023 is not expected to post gains much above 0.5%. One of the reasons for a recession being avoided has been the willingness of households to run down excess savings balances and firms to continue hiring. However, as we move forward towards 2024, households are expected to increasingly look to replenish these savings balances, particularly in the face of a slowing labour market, with a concomitant reduction seen in spending.

  • Acting as a further drag on growth will be the impact of higher mortgage rates. The popularity of fixed term mortgage rates in the UK has meant that some of the impact of the BoE’s monetary tightening delivered to date has yet to be felt, with many mortgage holders in the UK still to see their disposable incomes significantly squeezed. But this squeeze will come and will be more drawn out than has been seen in past tightening cycles as the drag from higher rates will be felt for longer until all current fixed rate mortgages have expired. In addition to this, many mortgage holders will likely prioritise making overpayments each month in order to reduce their outstanding mortgage debt as much as possible before being required to re-mortgage at a higher rate; or alternatively by maximising savings to pay off a stock of debt when they refinance.

  • In the corporate sector, the higher cost of finance will force firms to increasingly look to cut costs. Around 80% of UK business loans are floating rate, meaning that the effective interest rates these firms are now facing on their borrowings is higher than 6%, more than double the average rate faced at end 2021. This higher cost will depress corporate profits, which have already been reduced by the decision of the UK government to raise the rate of corporation tax from 19% to 25% alongside less generous capital allowances. The consequences of these things mean lower levels of employment and reduced capital expenditure and, by implication, less impetus to growth.

  • The main driver that has facilitated the UK avoiding a recession has been stronger domestic consumption than anticipated at the start of the year, a situation that is expected to continue going forward. Non-mortgaged households – around 70% of the total – with savings balances will have seen a sizeable boost to their disposable incomes from the strong rise seen in deposit rates. Tellingly, household bank deposits now equate to approximately 98% of outstanding loans, a sharp increase from the 76% average rate seen over the past couple of decades, meaning that any drag on consumption from higher interest rates is being offset by a boost to consumption from increased interest earnings.

  • The signs of softness that were being in the labour market are gathering momentum with the headline rate of unemployment set to continue rising going forward. It is already at the BoE’s estimated 4.25% equilibrium rate and looks set to potentially pass 5% over the course of the next year. The number of vacancies is also continuing to rise, the 3-mth average vacancy to unemployment rate – they key measure of labour market tightness for the BoE – now having fallen to 0.71 from the peak 1.05 level seen in August 2022. This reduction in demand for labour will increasingly bring downwards pressure on wages growth as employers gain the upper hand in wages negotiations and the upwards pressure on renumeration from labour market churn fades. Of key significance here is that lower wages growth should quickly see downwards pressure in services sector pricing, given that wages are the major cost for most services firms. This will translate into a quickening pace of decline in core CPI.

  • Inflation finally looks to be on a downwards trajectory and we expect the headline annual rate to finish the year around the 5% mark. Although rising global oil prices will act as a drag on this move lower, a significant boost to lower CPI will come this October from the further 7% reduction in the UK’s default energy price tariff. Producer pricing data is also pointing to a slowing in consumer goods prices going forward, and, more significantly, services CPI inflation, a category that has been remarkable resilient to the impact of the BoE’s monetary tightening so far and preventing core CPI from tracking lower.

  • The BoE has provided no indications on how far CPI must fall before it will consider cutting rates, but it will be aware of the delayed workings in the transmission mechanism. It will therefore be more cautious about cutting rates than hitherto. However, the BoE has signalled that once the terminal rate has been reached, interest rates are expected to be kept on hold for an extended period rather than cut. Accordingly, no cut in interest rates is envisaged until at least late H1 2024.