Monthly UK Economic Outlook: July

Source: S&P Global Markit

Headline UK inflation holds steady 

The UK’s headline inflation rate remained stable at 8.7% year-on-year in May, once again exceeding both the consensus expectation of 8.4% and the Bank of England’s forecast of 8.3%. Higher prices for cultural goods, services, recreation, hospitality, and air fares were the main culprits – for example, airline fares were up 20% in May, compared with 2.8% for the same month last year. Meanwhile, goods inflation eased from 10.0% in April to 9.7%, while food inflation dropped from 19.0% to 18.3%.

The key point here is that persistent core inflation is overtaking the drop in energy prices. Core inflation (excluding food and energy) rose from 6.8% in April to 7.1% in May, its highest rate since March 1992. This was led by a sharp rise in services inflation, indicating persistence in domestic inflationary pressures. This is of special interest to the Bank of England, which is worried about second-round effects linked to rapidly rising wage pressures. We may now be in the early stages of a wage-price spiral.

Nonetheless, headline inflation could fall sharply over the coming months. Ofgem will reduce its energy price cap by 17% in July and wholesale prices suggest that energy will make a negative contribution to the headline rate soon. Food inflation should also fall over the coming months. Producer input price inflation eased sharply in May, down from 4.2% in April to 0.5%.

But services inflation will probably take longer to fall, with the latest PMI data suggesting that prices in the services sector are still high, even though they are easing slowly.

Overall, sticky core inflation remains the biggest challenge for policymakers.  

Energy and food prices falling but core inflation proving persistent: inflation (% year-on-year)

Source: UK Office for National Statistics (ONS)

Strong wage growth likely to lead to further monetary tightening

Both the unemployment rate and redundancies remain low. The unemployment rate inched down by 0.1 percentage point to 3.8% in the three months to April, while redundancies only crept up from 2.8 per 1,000 in March to 3.3 – still a historically low level.

Meanwhile, wage growth accelerated again in the three months to April, with growth in regular pay (excluding bonuses) up from 6.8% in March to 7.2%. This will put further pressure on the Bank of England to raise the rates as it strengthens the argument that inflationary pressures are not yet under control.

However, the market isn’t nearly as hot as headline employment suggests. Labour demand is essentially flat, with vacancies down for the 13th month in a row in May. And as we’ve explained previously, while total employment might still be rising, that’s mainly due to increased numbers of self-employed and part-time workers.  That’s because firms are focusing on cutting costs amid rising borrowing costs. Overall, slack is developing slowly.

Meanwhile, labour supply is picking up. Cost-of-living pressures have been pushing down inactivity since the start of the year, notably among students and early retirees. In the three months to April, the UK’s economic inactivity rate was 21.0%, 0.4 percentage points lower than the previous three months. And immigration is picking up swiftly. According to the UK KPMG-REC Jobs report, total staff availability increased at its quickest rate since December 2020 in May. That said, there are still shortages in some areas – especially chefs, hospitality, cleaners, and drivers.

Overall, the labour market has been resilient so far. We expect that to change gradually as 2023 progresses, but it’s likely to remain an area of relative strength. 

Wage growth continues to be higher than expected: regular pay growth (% year-on-year, quarter-on-quarter)

Source: UK Office for National Statistics (ONS)

Rates higher for longer 

The Bank of England delivered a surprise 50 basis point hike to 5% at its June meeting, its 13th consecutive hike and bringing rates back to mid-2008 levels. The market reaction was fairly muted, still expecting a peak of 6-6.25% by year-end. Further hikes look likely due to the stickiness in both UK consumer price inflation and private sector wage growth.

But could there be fewer rate hikes than the market expects? It’s possible, as slack in the labour market is likely to increase and inflation and wage increases will slow down over the coming months. In short, there’s still considerable uncertainty about the path of interest rates as a range of opposing factors are at play. But over half the tightening that’s occurred to date is still to hit the economy, so the Bank of England needs to tread carefully.

Financial markets expect peak interest rates of 6.0%, up from under 5% just over six weeks ago: market pricing for Bank Rate at future Bank of England meetings

Source: Bloomberg Finance L.P