Even though the U.K. economy saw no growth in the final quarter of 2022, this outturn was still better than we had expected against a background of record-high inflation that continued to erode household purchasing power.

Table 1

As a result, the economy is on a somewhat firmer footing going into 2023, supported also by what has been a relatively mild winter, which helped with household energy bills. Higher frequency data also suggests a slightly more optimistic start to the year, on balance.

That said, the broader picture for this year is still one of economic weakening. The economy had already been stagnating from second-quarter 2022--the lion's share of the 4% growth reported for full-year 2022 was actually a carry-over from the previous year. And as double-digit inflation and much higher costs of borrowing continue to feed through, the U.K.'s economic situation is set to worsen slightly, in our view, before it starts improving later this year.

Chart 1

No Growth For Now

We now expect the U.K. economy to shrink by 0.5% this year. Falling private consumption and investment will be only partly offset by growth in government consumption and a positive contribution from net trade.

We had previously anticipated worse--a 1.0% decline. Our improved forecast reflects, among other factors, a more rapid decline in headline inflation, which we now see averaging 5.8% in 2022 compared with 7.0% previously. This, in turn, stems from easing energy prices, particularly for natural gas on which the U.K. relies heavily for electricity production and heating.

Chart 2

The March 15 budget measures should also help boost growth moderately from mid-2023. In particular, once inflation uncertainty recedes, business investment should start benefitting from the 100% tax deductibility granted for certain types of investment. In addition, expanding free child-care allowances should help labor participation rates recover and, along with other similar supply-side measures, lift the U.K.'s growth potential in the medium and longer terms. Considering these measures and other, partly technical, factors, we have raised our medium-term growth forecast to about 1.6% in 2023-2026, on average. Even so, however, we do not currently see the U.K. economy catching up to pre-pandemic trends over our forecast horizon.

Higher-For-Longer Inflation Still A Challenge

A mild winter and the faster structural adaptation of energy infrastructure and supply chains in continental Europe, among other factors, have eased energy prices. And as earlier increases in those prices are starting to fall out of the inflation rate calculations, the energy component is set to exert marked downward pressure on headline inflation this year.

However, we think U.K. food price inflation--currently at a record high 18%--could take longer to come down as input costs continue to feed through to agricultural production and Ukrainian output constraints persist. U.K.-specific capacity limitations, notably the lack of seasonal workers and ongoing food supply chain issues, add to this picture.

The U.K. labor market started to slightly erode a few months ago. For instance, recent employment growth has shifted to the creation of less-secure jobs (part-time) at the cost of more-secure jobs (full-time). But the market remains extremely tight, not only in relation to the current economic weakness but also in absolute terms. Vacancies and unemployed numbers have remained close to historical highs and lows, respectively. Labor market strength will continue to give workers additional leverage when negotiating wages, translating into ongoing strong wage growth, albeit at a diminishing pace, and adding to price pressures. We expect wage growth to remain above 3.5% going into 2024, by then outpacing inflation and therefore starting to recover some recent losses in purchasing power and supporting growth.

Chart 3

Wage inflation is fueling domestic services inflation and, more generally, core inflation--the stickier component of headline inflation. While we think core inflation may have peaked in fourth-quarter 2022, we also believe it will be even slower than wage inflation to come down, still averaging around 6% this year. Only next year, when tighter monetary policy and the impact of weaker economic growth take full effect, will core inflation ease faster.

Monetary Policy Just Got Trickier

In its February meeting, the BoE signaled that its 4% rate might be sufficient to achieve its 2% medium-term mandate for inflation. However, that decision was made before January's positive GDP growth data was released and before the government revealed its moderately expansionary budget, both of which lifted the growth outlook for this year and beyond, while February inflation accelerated unexpectedly. It came as no major surprise when the BoE raised its policy rate to 4.25% on March 23.

Recent global bank failures show how aggressive interest rate hikes can undermine financial stability if there are pre-existing vulnerabilities in just a few banks. U.K. banks do not have asset exposures anywhere close to those of SVB, nor do they have the same structural issues that brought about the demise, and UBS acquisition, of Credit Suisse. In fact, U.K. banks remain on solid foundations (see "Interest Income Fuels Bumper U.K. Bank Profits As Rates Near Their Peak," published March 10, 2023, on RatingsDirect), a view we share with the BoE. Moreover, S&P Global Ratings believes that even if policy rates were to moderately increase further, this would be a net positive for U.K. banks.

Chart 4

Even so, the U.K. is tightly integrated into the global financial system and has not been spared market turmoil and repricing. Beyond finding the right trade-off between short-term demand-cooling and bringing inflation close the 2% target in the medium term, the BoE now also has to consider to what extent tighter credit conditions, globally and in the U.K., will add to the effects of already restrictive domestic monetary policy.

On balance, we think the BoE in March might have raised interest rates for the last time this cycle, unless core inflation proves even stickier than anticipated, which remains a risk. Otherwise, we believe it could even start easing its policy again as early as next year when it should become clear that core inflation is indeed falling as expected. We expect the bank rate to reach its long-term level of 2.5% by 2025. This will be earlier than in the eurozone, where core inflation has yet to peak and headline inflation is set to remain higher for longer than in the U.K.

Meanwhile, even as core inflation remains well above 2%, headline inflation will undershoot the target significantly in 2024-2025 due to energy and food price inflation turning negative, something the BoE will need to tolerate to ultimately bring overall inflation back to target.

Downside Risks Continue To Circle

Risks to global sentiment and energy and commodity prices from an escalation of Russia's war on Ukraine remain elevated, although less so than a few months ago partly thanks to continental Europe's better preparedness for next winter.

The U.S. government and the Fed's swift actions, in the form of deposit guarantees and additional liquidity, appear to have contained the risk of contagion from recent U.S. bank failures to the U.S. and global banking systems, although it is too early to assess the full fallout.

Even though these events have already led to increased market volatility and tighter credit conditions despite the interventions, at this stage central banks appear unlikely to be sufficiently challenged to renege on their current commitments to bring inflation in check as illustrated by the BoE's recent announcement. However, in conjunction with intensified caution over bank lending, this will likely tighten financing conditions further. Any tightening beyond what we already assume would represent a downside risk to our forecast.

However, even if market turmoil remains a challenge, it would not necessarily prevent central banks, including the BoE, from continuing to pursue restrictive monetary policy. In fact, direct liquidity injections would be much more effective at restoring market liquidity than lowering policy rates, and the BoE could adopt such a dual approach with plenty of levers to pull if required.

On Feb. 27, the U.K. government and the EU agreed to the so-called Windsor Framework, which intends to simplify goods trading between mainland Great Britain and Northern Ireland. Under the framework customs checks would only apply to U.K. goods exports headed to the EU via Northern Ireland, with little to no impediments to intra-U.K. trade flows. Moreover, the agreement could pave a way for a gradual broader improvement in UK-EU relations, which in turn could help settle persisting uncertainty over these relations and therefore brighten the longer-term outlook for both U.K. trade with the EU and related investment.

Related Research

• Interest Income Fuels Bumper U.K. Bank Profits As Rates Near Their Peak, March 10, 2023
• The Macro Fallout From The Silicon Valley Bank Collapse Appears Limited For Now, March 16, 2023
• Global Credit Conditions: A More Difficult Way Out, March 20, 2023