U.K. inflation stood at 9.1% in May--a multi-decade high. This level alone will depress household spending power dramatically, weaken spending, and ultimately contribute to negative GDP growth this quarter and next. Growth in the second quarter will also be lower because the government has all but stopped spending on both testing and tracing and on the vaccination roll-out at the end of March.

But there is more: To bring inflation back down to the target of 2%, the Bank of England (BoE) will continue raising its policy rate into early next year, to reach 2%, before pausing for a few quarters. While policy tightening is necessary and even beneficial for medium-term growth, it comes at a short-term cost. Higher funding costs, will exacerbate downward pressure, mainly via weaker investment, but also by reducing wealth. These effects will be compounded by already tighter market conditions in the U.K. and around the world.

Some downside risks to our earlier forecast have materialized. Specifically, a resolution to the Russia-Ukraine war is not in sight and market repercussions are not abating. Global energy prices have remained high and prices of global food commodities have increased. While the latter feed through global and domestic supply chains, inflation is unlikely to come down rapidly, weighing on activity for longer than we previously thought.

In view of these recent developments and especially the outlook for inflation, we have revised down our outlook for the U.K. economy. We now forecast GDP growth of 3.2% this year, 1.0% next, and 1.7% and 2.0% in 2024 and 2025, respectively. We expect inflation to reach 10% by the end of the year, and to stay high for most of 2023.

A Hidden Technical Recession In 2022

Despite a strong looking growth rate of 3.2% for this year, a technical recession--negative GDP growth over at least two consecutive quarters--is now highly likely.

Chart 1

In fact, the annual numbers hide the very weak outlook for the rest of the year. The apparent disconnect between quarterly and annual numbers has to do with how last year's GDP profile determines this year's growth rate. The so-called carry-over (or base effect) dominates for this year--of the 3.2% growth we currently forecast, 2.8 percentage points are due to last year's GDP profile (see chart 1)

The Inflation Squeeze Has Started

Employees have enjoyed extraordinarily strong wage growth since mid-2021. In April, total pay growth in the private sector had risen to 8%, holding up well with the pace of inflation. A sizeable portion of this number is explained by large sign-up bonuses for new employees against the backdrop of a very tight labour market.

But the previously favourable trend in real private-sector wages has likely reversed since then, and we expect it to worsen before it improves again. As activity weakens, employment growth will also soften, if not stall, and pay growth, although still strong in nominal terms, will not be able to keep pace with inflation until well into next year. By the end of the year, real wages could be 4%-5% lower than a year earlier. On average, households will be able to afford less and, therefore, buy less, due to this loss in purchasing power.

The situation is worse for public-sector staff for whom wages have risen by just 1.5%, well behind the pace of inflation. However, if ongoing and planned industrial action by unions is successful, public-sector wages could rise by 5% later this year.

Revised numbers from the Office of National Statistics show that in the fourth quarter last year, households had already not saved significantly more they did just before the outbreak of the pandemic. More recent BoE data show that the use of consumer credit, including credit cards, has increased since February this year, to above 2019 levels. The widening gap between retail sales in volumes and values fits the same picture and signals the beginning of the inflation squeeze (see chart 2).

Chart 2

At the same time, some households still have sizable savings at their disposal--accumulated during the pandemic--that can provide a buffer to higher inflation. However, savings are concentrated in the middle- and higher-income households, while lower income households have now likely depleted any excess savings from 2020-2021. These households are set to suffer the most from high inflation because basics such as energy and food occupy a larger share in their overall spending, and because those items in particular have, or will, become more expensive in the quarters ahead. However, we think the impact will likely be significantly mitigated by the government's £15 billion support package aimed at these households.

But even households with larger cash buffers might spend less. The recent drop in equity prices has eroded financial wealth, while higher yields have increased returns. This might limit these households' willingness to tap into savings to offset the impact of higher inflation.

While these factors play an important role, there still exists considerable pent-up demand. To satisfy it consumers might be willing to stretch their budget more than high inflation numbers imply, which should help to soften the blow to the economy. Still-high discretionary spending in some areas, notably in the hospitality and tourism sectors, support this view.

The inflation shock has hit the economy at a time when it was already naturally slowing following the recovery boost, but it could have come at a worse time. In particular the labour market is very strong, with a record high stock of vacancies. Indeed, vacancies were still rising as recently as May, to 1.3 million (about 500,000 more than prior to the pandemic). And we expect the labour market to remain comparatively resilient even during temporarily faltering economic activity, with employment growth only stalling at worst and unemployment rising only moderately. This means that support from wage income will remain broad-based during this period of high inflation--a major, and positive, difference versus historical inflation shocks.

Monetary Policy Tightening Continues, But Below Market Expectations

Global energy markets continue to show significant volatility, notably in natural gas prices, most recently when Russia limited its supply of gas to Europe. Russia's invasion of Ukraine has severely impaired Ukraine's ability to supply global markets with the food commodities of which it is a major producer. Prices of such commodities have risen and could rise further, also pushing U.K. food inflation higher.

While much of U.K. inflation is still caused by global price developments, domestic pressures have been increasing at the same time. This can be observed in domestic services, still driven by reopening effects, but also in core goods as higher costs--from less favourable trade with the EU and persistent supply chain issues--feed through the production chain.

Chart 3

In addition, the regulator's cap on the prices that energy retailers can charge households will most likely be increased again and significantly so in October this year. This lagged pass-through of global prices to household bills means inflation will rise again in October and stay high until the third quarter of next year when we expect it to finally slip below target as previous pressures fall off or reverse.

The longer high inflation persists, the higher the risk that it becomes entrenched, possibly creating an unfavourable wage-price inflation dynamic that could keep inflation high for longer even as global pressures abate. Wage negotiation outcomes and businesses' pricing intentions suggest that this may have already started.

Curbing this development as much as possible, if not preventing it altogether, is the BoE's current main challenge, in our view. With its latest hike to 1.25% in early June, once more out of schedule and in relatively quick succession after the hikes since December, it is trying to do just that.

But the central bank has a very difficult task at hand. It must weigh the additional short-term pains that higher funding costs inflict on the economy, against the long-term benefits from lower inflation--and do so in the context of unusually high uncertainty at home, but especially abroad.

That the labour market and wage growth are so strong is a double-edged sword in that trade-off. On the one hand, high employment and wage growth make the economy more resilient to higher interest rates. On the other, they are a key part of the reason why the BoE worries about inflation in the first place.

On balance we think the BoE will continue to hike by a further 25 basis points each quarter until the policy rate reaches 2% in early 2023. This is less than what the markets have priced in. But, in our view, market conditions have tightened somewhat beyond what BoE guidance would imply, driven by a combination of worries over geopolitical risk, high inflation, and in particular the reaction to the Fed's now much more aggressive policy path. This market response will do some of the BoE's job, without the bank having to go all the way itself.

Forecast Risks Are Mostly On The Downside

There has been no let-up in uncertainty since the beginning of the pandemic more than two years ago. Most recently Russia's invasion of Ukraine and its repercussions for global energy prices have pushed already high inflation into overdrive.

Our forecast relies on the assumption that the conflict does not widen geographically or involves the use of weapons that the West would find intolerable. Should the conflict broaden, it would likely have a more detrimental impact on global equity prices and shut down part of Europe's industry that relies heavily on Russian gas imports. In the U.K. this would be mainly felt through trade and global market conditions.

Although the U.K. labour market looks resilient, it is unclear how it would react if the global environment weakened more than we currently expect, for example because of an overreaction of the global markets to ongoing aggressive monetary policy tightening in the U.S.

There is also a question as to what extent previous years' shocks have affected, and will still affect, the U.K. economy's growth potential. Even if there is little damage domestically, it still depends on global supply chains, which might take longer to repair, and energy markets that could take longer to normalise. A protracted return to normal, globally, would significantly weigh on the U.K.'s growth path.