Recovery Continues Amid Rising Inflation

For now, the U.K. economy continues to recover at a rather fast pace. Driven mainly by household consumption, it is set to regain pre-pandemic levels sometime in the first quarter of next year. From trough to peak, it will have taken just under two years--much faster than, for example, the four long years it took the economy to recover lost ground after the financial crisis of the past decade.

However, as the initial recovery drive abates, economic growth will--naturally and gradually--slow. After GDP growth of 6.9% expected for this year, we forecast 4.6% growth next year, with GDP still benefiting substantially from the recovery drive. In 2023, growth will likely slow to 2.2%, and then to 1.9% in 2024.

We might see higher growth if the economy proves to have incurred less permanent scarring, or if structural changes induced or accelerated by the pandemic turn out to be more productive than we currently expect. The magnitude of scarring is still difficult to assess, partly because it is entangled with Brexit effects, although there is much that suggests pandemic effects dominate. At the same time, there is still quite a distance to go before a robust assessment can be made of any potential productivity gains. For now, we think that in 2024 the economy will still be about 3% short of where it might have been had the pandemic not taken place.

We expect inflation to average at 4.5% in the first quarter of 2022, and it could even reach 5% in individual months. However, we think high inflation will do less damage to household spending this time around against the background of pent-up demand, strong wage growth, and a large stock of savings. There are, however, important compositional aspects: as so often the case, lower-income households will feel the pinch most.

We now expect the Bank of England to hike the bank rate twice next year to reach 0.5%, from currently 0.1%, to preempt high inflation becoming entrenched over the next few quarters. As long as the BoE limits hikes within that range, any effects on the economy as a whole, even when still in recovery mode, should be limited, if not offset altogether by the beneficial effects of keeping inflation well anchored.

Table 1

Pandemic Risks

A new spike in the pandemic, similar to what some continental European countries are already experiencing, remains a risk to our forecast. But even if hospitals were to come under acute pressure, we do not envisage the government implementing measures anywhere near as stringent or all-encompassing as in the past, but rather much more targeted measures.

Fresh, albeit targeted, restrictions would still weigh on the recovery, but, in our view, they are unlikely to derail it altogether. A key mitigant is that the economy has now adapted well to operating under mandated restrictions, with a moderate impact on growth overall. Of course, this does not preclude the fact that certain sectors, such as hospitality and travel, might still be much more affected than others. Having said that, natural immunity gained at the cost of an elevated incidence since the reopening of the economy in July, along with a successful booster shot drive, might shield the U.K. from a significant deterioration. Generally, however, our forecasts remain contingent on pandemic developments, including the emergence of new variants, such as Omicron, that could pose a risk to the current path of normalization.

Uneasiness About High Inflation

Consumer price inflation rose to 4.2% in October, well above the Bank of England's (BoE) self-imposed target of 2%. It's important to recognize that excess inflation is currently still predominantly driven by global and domestic supply-chain constraints, globally higher prices of raw materials, imported goods that use them and--most importantly--higher fuel and energy prices. Unless energy prices continue to rise next year--they do not even need to fall--this part of inflation will be transitory and start falling. Indeed, while we think inflation could hit even 5% in March or April, we forecast it will fall thereafter and end the year just above 2% (see chart 1).

Chart 1

There is nothing really a central bank should, or can, do to curb that kind of inflation. Monetary policy is unable to speed up the matching of jobs with workers, resolve supply-chain bottlenecks, or increase gas production. Tightening policy here would even be detrimental to the economy.

The BoE is less worried about that portion of inflation, which will be coming down on its own anyway. It is, however, uneasy about some of the pressures translating, through second-round effects, into persistently higher inflation over the medium term, even when external price pressures have subsided--a type of inflation that is detrimental to economic growth but can be addressed by monetary policy. A key component of those second-round effects is an excessively tight labor market and, specifically, wage growth that is too strong compared with the productive capacity of the economy.

Thanks to the government's job support scheme, unemployment rates have risen only a little during the pandemic, from 3.8% before COVID to a high of just 5.2%. The scheme closed at the end of September, when a reported one million workers were still furloughed. The full impact of the end of the scheme will only be visible in the next few months when more data becomes available and also covers delayed job losses as notice periods expire. However, data available so far suggest that the impact has been quite benign, and further key data that could support that view will be released days ahead of the BoE's Monetary Policy Committee meeting in mid-December. The bank might have seen enough on unemployment numbers by then to hike rates there and then, if it were not considering other factors, too.

Chart 2

Indeed, while wage growth has remained elevated, it has now started to decelerate as difficulties in matching jobs with workers are easing. Difficulties will nevertheless persist in some sectors due to now much more restrictive rules for immigration from the EU. However, they are unlikely to support excessively high wage growth across the economy. Moreover, in our view, current robust wage growth will be more than covered by productivity gains through the medium term, and for that reason we see the risk of a vicious wage-inflation spiral as very limited.

Chart 3

Factoring in the risk from a deterioration of the pandemic, we think the BoE may want to wait to see how wage growth develops and confirm that the pandemic situation remains under control before making its move. We assume this will be the case, and expect a first 15-basis-point hike in February, followed by a 25-point hike in May, at a time when inflation will still be high. Any later, and the bank would have difficulty justifying a hike just as inflationary pressures are evidently abating, and miss the opportunity to move rates further toward pre-pandemic levels.

The anticipated hikes would take the policy rate to 0.5% from May. At a higher rate, the BoE would have to start reducing its balance sheet as early as that month, according to its own guidance, by not reinvesting redemptions. The more moderate 0.5% that we expect will also prevent the bank having to pull back in early 2023 when inflation should fall below 2%. In the absence of new, sizable shocks, we expect little detrimental impact of monetary policy tightening on the economy overall.

Beyond 2022, we continue to expect that the BoE will normalize monetary policy cautiously and gradually, with no further hike before August 2023.

Consumers Remain Key

The outlook for the U.K. economy largely hinges on the outlook for the U.K. consumption given its large share in GDP (62% prior to the pandemic). The good news here is that even though high inflation will likely dent spending growth somewhat over the next few quarters, it will do little to the material recovery and catch-up momentum still at play. Rising employment and income growth, that will remain positive in real terms even as inflation accelerates, will continue to underpin this momentum.

More importantly, by the end of the third quarter of this year, households had accumulated savings exceeding pre-pandemic levels, by a staggering 10% of 2019 GDP (see chart 4). This resulted from a situation where the government provided income support while spending options were restricted, but also reflects a degree of precaution. These savings will now become an important buffer to absorb higher costs.

Chart 4

However, despite a largely unrestricted economy since July and a tightening labor market, households are still saving more than usual. In Q3 this year, they saved around 10% of their income, more than double the 4.6% average in 2019. It doesn't look like households' savings attitude will change dramatically in the near term, and dissaving looks even less likely. Rather, we see the savings rate declining gradually but staying above pre-pandemic levels at least until 2024, due to precautionary motives. However, the decline in the rate will still underpin higher household spending growth over the whole horizon, even though some of the extra money, both from the accumulated stock and ongoing savings, will be absorbed by the housing market.

While this is true for the household sector as a whole, there are important distributional effects to be considered. Lower-income households saw little opportunity to save much, even during lockdowns, as the bulk of their income was spent on nondiscretionary items, such as housing and food. This is the segment where the propensity to spend is greatest when income or savings rise. For the same reason, it is also where inflation will hit hardest, especially higher fuel costs over the winter and into spring. As a result, the boost to spending in the economy as a whole will turn out more moderate than if savings opportunities had been distributed more widely.

However, there is also a significant upside risk to overall consumer spending. Should households change their attitude toward risk and saving more quickly and start spending more, economic growth could turn out higher.

S&P Global Ratings believes the new Omicron variant is a stark reminder that the COVID-19 pandemic is far from over. Although already declared a variant of concern by the World Health Organization, uncertainty still surrounds its transmissibility, severity, and the effectiveness of existing vaccines against it. Early evidence points toward faster transmissibility, which has led many countries to close their borders with Southern Africa or reimpose international travel restrictions. Over coming weeks, we expect additional evidence and testing will show the extent of the danger it poses to enable us to make a more informed assessment of the risks to credit. Meanwhile, we expect the markets to take a precautionary stance and governments to put into place short-term containment measures. Nevertheless, we believe this shows that, once again, more coordinated, and decisive efforts are needed to vaccinate the world's population to prevent the emergence of new, more dangerous variants.