The U.K. economy has rebounded to pre-pandemic levels of activity but now faces a historical surge in inflation. Russia's invasion of Ukraine has added extra pressure to already high global energy prices. Tighter monetary policy will add to the headwinds this year and into next year but should be beneficial thereafter by preventing inflation from becoming entrenched. More generally, both domestic and global financing conditions have also tightened and will be felt.

We have revised down our GDP growth forecast for the U.K. and now expect 3.5% for this year, compared with 4.6% in December. We see inflation averaging 6.3% this year, peaking at 8% in the second quarter before it gradually declines, barring an escalation of the conflict.

If a fresh energy price shock had to happen, now is not the worst time. In fact, were the economy not still benefiting from some recovery momentum and a carry-over from 2021 worth 2.6% of annual growth this year, we might be expecting the U.K. to be on the brink of recession. But, as things stand, growth will continue. This makes all the difference for future growth dynamics because no actual destruction is taking place. This extends to the labor market, which we expect to remain strong, with unemployment to rise only minimally if at all.

Table 1

More Inflation

The U.K. is one of Europe's economies least directly exposed to Russia or Ukraine and, therefore, we expect very little direct impact from the conflict. But it is of course exposed to global energy prices, which rose even higher when markets responded to Russia's invasion of Ukraine. This alone will add upward pressure on already high inflation, which was running at 6.2% in February.

The February reading will soon be eclipsed in April, when energy regulator Ofgem's 54% increase in the cap on prices that energy providers can charge households will come into effect. Along with other factors, this could push inflation up to 8%, or even above.

Chart 1

The bulk of excess inflation will be short-lived, provided energy prices in 2022 do not rise beyond averages seen in the second half of 2021. In fact, they should decline later this year, reversing the main inflationary pressure currently at play. Recent falls in gas prices are encouraging if they are not merely an expression of a currently extremely volatile energy market.

Our base case view of global energy prices declining later in the year rests on the assumption that the conflict will not escalate and will remain contained geographically. Should the conflict widen, global energy prices could stay as elevated as they currently are or rise even higher. In that case, indirect negative effects would mount, and the U.K. economy would see further and longer-lasting inflationary pressures, not least because Ofgem would be bound to lift the price cap once more in October. This is a significant downside risk to our forecast.

However, even in our base case some of the inflation momentum will be sustained for longer. The catch-up of wage growth from losses during the pandemic and subpar growth in the period prior is set to continue, on the back of a very tight labor market. In addition, some supply chains issues will persist or even intensify, even though supply chain performance had been improving recently (see chart 2). Indeed, supply chains are still catching up with the re-opening of the economy, and new pandemic restrictions in China (as part of its zero-COVID-19 strategy) could create fresh disruptions.

Chart 2

Some More Monetary Policy Tightening--But Not That Much

There is little the Bank of England can do to curb imported cost inflation, which normally is transitory anyway. It is the risk of more persistently high inflation in the medium term that the Bank of England is trying to avert. In mid-March, it hiked rates for a third time in a row, bringing them back up to pre-pandemic levels of 0.75%.

The main driver of inflation in the medium term is wage inflation. The potential reemergence of the overly strong wage growth seen in 2021 is a key concern in the BoE's assessment. And indeed, the labor market looks as tight as ever. The unemployment rate is close to historical lows, while vacancy rates are at their highest on record, strengthening workers' bargaining power (see chart 3). In addition, without policy intervention, higher inflation expectations would likely translate into higher inflation adjustments in wage negotiations and settlements.

Chart 3

However, current labor market tightness is not coming from a generally overheating economy. In fact, while a sizable recovery momentum remains, the economy is now already naturally slowing following the main recovery phase. Current labor market tightness is better explained by several other factors: the inability of hiring to keep up with the speed of the reopening of the economy, difficulties matching jobs with skills, a labor shortage from a collapse in immigration from the EU and from a low participation rate that has yet to recover to pre-pandemic levels--if it ever will. In fact, had the participation rate recovered, the unemployment rate would stand at 5.5%, compared with the 3.9% reported for January. Beneath the surface, the labor market also looks somewhat less tight, with an increased number of jobs in the gig economy and working hours still below pre-pandemic levels.

This unconventional picture has important implications for monetary policy. First, it is less likely that strong wage growth can be sustained. There is a chance that wage growth moderates naturally as the economy slows further, matching difficulties ease, vacancies are filled, working hours recover, and higher wages incentivize new workers to enter the labor force. In our view that mitigates the risk that wage growth becomes detached from economic fundamentals. Second, with the economy already slowing, tighter monetary policy may have more of a cooling effect than usually, so that less action might be needed to achieve the same inflation target. Indeed, while we think that some further policy tightening may still be required, its extent may be much more limited, in our view, than what is implied by market expectations—that price in several more hikes and see the policy rate at around 2% by the end of the year. We expect the BoE to hike once more at its May meeting this year, to 1%, but then pause until after 2023, in line with its unchanged approach of cautious and gradual policy normalization in the longer term.

Less Growth

In a notable move, the government recognized the virus as endemic and, as part of its "Living with COVID-19" strategy, lifted all previous restrictions. This has certainly helped the economy and will continue to do so. Despite a resurgence in cases recently, critical cases have remained low, justifying the government's move. However, there is still a chance that a more harmful variant emerges that may require the reintroduction of public health measures, which are likely to be more limited and targeted than previously and significantly less harmful to the economy Nevertheless, this remains a downside risk to our forecast.

After the omicron wave over the winter, households once more had some catching up to do, and spending at the beginning of the year looks to have been strong. But inflation is set to surge in the next two months, most notably when the energy regulator Ofgem's new and much higher caps on energy bills come into force in April. Historically high inflation will depress household spending growth this year and into next. While many households can tap into large amounts of extra savings accumulated during the pandemic to absorb higher costs of living, lower-income households cannot, and the few measures the chancellor has announced in his Spring Statement on March 23 will provide very little relief. Stronger wage growth and ongoing job gains should offset the impact somewhat but, overall, real incomes will be hit hard, and household spending should grow little within this year. The growth rate of 4.5% that we expect for consumer spending is almost entirely explained by a carry-over from last year. Looking further ahead, inflation is set to fall rapidly from the second quarter of 2023 and should undershoot the 2% target later that year. This will reinvigorate household spending and underpin GDP growth.

Summary Of Risks

Risks to our forecast are concentrated on the downside. While the emergence of new COVID-19 variants still poses a risk, this has lessened and is now dominated by uncertainties surrounding the Russia-Ukraine conflict and its impact on global energy prices, trade, supply chains, and confidence.

That said, under most reasonable scenarios full-year growth in 2022 should still remain positive. Even a further rise in global energy prices by 50%, and lasting all of 2022, would not push the economy into a full-year recession, unless additional factors amplify the shock:

• A collapse in consumer confidence, as a result of which households would save more and spend less;
• Outright cuts of Russian gas supply to Continental Europe, which would impact the U.K. economy via trade and supply chains;
• More acute direct supply chain challenges, should substitutes prove difficult to find for industrial and food commodities imported from Russia or Ukraine; and,
• A significant deterioration in global financing conditions.