This report does not constitute a rating action.
Key Takeaways
- U.K. consumers' purchasing power is gradually improving amid a resilient labor market, paving the way for a recovery of consumption, and lower energy bills have improved the terms of trade.
- Monetary policy will likely start easing in August as inflation cools, with rate cuts this year and next spurring investment and potentially adding about 2 percentage points to economic activity, albeit most of the impact will come in 2026 and 2027.
- Prospects for potential growth remain robust since demographic trends are still dynamic, and we anticipate a rebound in investment to boost productivity in sectors that have seen less improvements than others.
Slow growth and high inflation in the U.K. are expected to subside this year, but only slowly, since supply-side weakness is continuing to put pressure on prices (see "U.K. Economic Outlook 2024: More Stagflation Ahead," published Nov. 27, 2023). We expect growth will improve more markedly in 2025 as disinflation bolsters household spending along with a resilient labor market.
Consequently, we anticipate some relaxation of monetary policy in 2024 and 2025, which will feed through to the real economy in 2026 and 2027 by fostering an investment rebound. We forecast GDP to expand by 0.3% in 2024, before rising to 1.4% in 2025 and 1.7% annually in 2026 and 2027 (see the table at the end).
A Tight Labor Market Implies A Slow Decline In Inflation
Headline inflation in the U.K. was 3.4% year on year in February, down sharply from 10.4% a year ago. Lower prices of energy, food, and non-energy industrial goods all contributed to the decline. Yet, cost inflation in the services sectors remains high, at 6.1% year on year in February (see chart 1), on the back of robust wage increases.
Chart 1
Job vacancies have fallen, but not enough to trigger a rise in unemployment, since the labor supply remains slow to expand (see chart 2). The employment rate is still below pre-pandemic levels, with a lot of inactivity due to long-term sickness. Workers are therefore likely to retain sufficient bargaining power by the end of this year to get annual pay rises of 4.0%-5.0% in 2025 as they seek to catch up with higher living costs. Supply-chain disruptions in the Red Sea could also lead to an uptick in inflation in the goods sector. As a result, we forecast inflation will stay above the Bank of England's target until 2026--at 3.0% in 2024 and 2.3% in 2025--before returning to 2% the following year.
Chart 2
In The Meantime, Consumption And Terms Of Trade Are Looking Up
The result of a resilient labor market, robust wage increases, and slower inflation is that consumers' purchasing power is improving. What's more, households have held on to a large amount of savings since the pandemic (see chart 3). In view of this, we expect consumption to help stoke economic growth from the first quarter (Q1) of this year. Sentiment surveys such as S&P Global's PMI (Purchasing Managers Index) are already pointing to a rebound in activity in Q1, after a technical recession at the end of 2023, thanks to recovery in the services sectors.
Chart 3
With some relief from energy costs, consumers are likely to spend more on other goods and services, especially from April when the energy price cap is set to fall again. Lower energy bills are also improving the terms of trade, with import representing less of a drag on growth this year. We also expect demand in key export markets like the U.S. to remain strong, and some improvements in the Eurozone, especially toward the second half of this year.
Monetary Policy Easing Will Have The Most Impact From 2026
In this soft-landing scenario, growth gradually picks up this year but remains below potential, helping the economy absorb excess demand and reduce price pressures. This mainly occurs through still-high borrowing costs, which continue to curb investment. In particular, this is weighing on the residential property sector, where mortgage loan approvals have yet to pick up, and also on the public sector.
Consequently, we believe capital formation will likely shrink further this year. This will continue to constrain job creation, loosening up the labor market and ultimately easing price pressures, setting the stage for rate cuts in August. According to the market, there's a 57% probability of a rate cut in June, and an 82% chance of one in August.
Assuming lower interest rates from August, we forecast growth progressively returning to trend, making new investments more attractive, but mainly from 2026. This lag reflects two factors. First, we expect most rate cuts to come in 2025, when inflation is closer to 2.0%. Second, we estimate it takes 1.5 to 2 years for a change in monetary policy to have its full impact on economic activity (see chart 4).
Chart 4
All other factors unchanged, we estimate that three rate cuts in 2024, six in 2025, and one in 2026 could add 0.2 percentage point (pp), 1pp, and 0.8pp, respectively to economic activity in 2025, 2026, and 2027 (see chart 5). That said, financial markets already expect rate cuts, and financing conditions have eased in a forward-looking manner. This will likely translate into some front-loading of the estimated impact of future rate cuts.
Chart 5
Three Reasons To Be Upbeat On The Supply Side
After slow growth in the U.K. over the past few years, we expect growth fundamentals to improve through 2025-2026.
First, business investment has started to recover from the post-Brexit slowdown. In some sectors, this is partly thanks to the government's full expensing scheme, which runs until April 2026. Investment in transport, machinery, and equipment may need to catch up after years of underinvestment (particularly in transport; see chart 6), so capital formation may be quite brisk.
Chart 6
Second, labor productivity--particularly in key services sectors--continues to rise. The market-based output per hour was 5.7% higher in June 2023 than in December 2016. The information and communication services sector saw a 40% increase in hourly productivity between 2016 and 2022, with its share of gross value added climbing to 7.6% in 2022 from 5.3% in 2016. This sector is thereby making the largest contribution to aggregate productivity increases. By contrast, productivity has stalled the most in the public sector and where there have been few investments (such as in transport, machinery, and equipment; see charts 7 and 8).
Chart 7
Chart 8
Third, the working age population is forecast to get bigger. the latest demographic projections from the Office for National Statistics point to a healthy increase in the workforce between mid-2021 and mid-2036, with the population seen to expand by 10%. This is a sharp contrast to some economies on the continent, like Germany and Italy, where the population is expected to shrink.
Risks To Our Soft-Landing Scenario Are Broadly Balanced
On the downside, geopolitical tensions could intensify and translate into more supply-chain disruptions or higher barriers to trade. This situation would spark new inflationary pressures, slowing the path to lower interest rates and the recovery in consumption.
On the upside, monetary policy loosening could come earlier if wage pressures fall more quickly than expected. But that could also come from a less resilient labor market, which would be synonymous with weaker growth.
| S&P Global's U.K. economic forecasts--March 2024 | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (%) | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | ||||||||
| GDP | 4.30 | 0.10 | 0.30 | 1.40 | 1.70 | 1.70 | ||||||||
| Household consumption | 5.00 | 0.40 | 0.40 | 1.50 | 1.80 | 1.80 | ||||||||
| Government consumption | 2.30 | 0.60 | 1.60 | 1.10 | 1.10 | 1.10 | ||||||||
| Fixed investment | 8.00 | 2.90 | (1.00) | 1.70 | 2.70 | 2.20 | ||||||||
| Exports | 9.00 | (1.40) | 0.70 | 2.90 | 2.90 | 2.70 | ||||||||
| Imports | 14.60 | (1.60) | 0.20 | 2.90 | 3.10 | 2.80 | ||||||||
| CPI inflation | 9.10 | 7.30 | 3.00 | 2.30 | 2.10 | 2.00 | ||||||||
| CPI inflation (Q4) | 10.70 | 4.20 | 2.90 | 2.20 | 2.00 | 2.00 | ||||||||
| Unemployment rate | 3.90 | 4.00 | 4.30 | 4.30 | 4.20 | 4.20 | ||||||||
| 10-year government bond rate | 2.30 | 3.90 | 3.80 | 3.40 | 3.30 | 3.20 | ||||||||
| Bank rate (end of period) | 3.25 | 5.25 | 4.50 | 3.00 | 2.75 | 2.75 | ||||||||
| Exchange rate ($ per £1) | 1.23 | 1.24 | 1.28 | 1.37 | 1.38 | 1.37 | ||||||||
| CPI--Consumer price index. Q--Quarter. Sources: Office of National Statistics, Bank of England, S&P Global Market Intelligence, and S&P Global Ratings (forecasts). | ||||||||||||||
Related Research
- U.K. Economic Outlook 2024: More Stagflation Ahead, Nov. 27, 2023
| Senior Economist: | Marion Amiot, London + 44(0)2071760128; marion.amiot@spglobal.com |
| EMEA Chief Economist: | Sylvain Broyer, Frankfurt + 49 693 399 9156; sylvain.broyer@spglobal.com |
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