The outlook for the U.K. economy has deteriorated further. S&P Global Ratings believes the country entered a multiquarter technical recession in the second quarter that will culminate in a 1% contraction in 2023. Yet, if our forecast about the magnitude of the recession is only broadly on target, it will go on the record as the mildest since 1960. Nevertheless, the pain may be felt more widely and acutely than in previous recessions. Most people will keep their jobs yet struggle to make ends meet---a constant worry owing to high inflation.

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The Economy Will Enter 2023 In A Weaker Position

Despite high inflation, GDP fell just 0.2% in the third quarter of this year, thanks to some one-off factors. But the monthly GDP indicator showed a single-month decline of 0.8% in September, which puts the economy on a weaker footing going into the fourth quarter and next year. Other indicators also continue to paint a rather bleak picture. Consumer confidence remains close to historic lows, and business confidence has dropped to its lowest levels since 2009. Recent Purchasing Manager Indices (PMI) are in the same vein. Particularly worrying is the steep decline in new manufacturing orders against the backdrop of external weakness, which doesn't bode well for production output in the quarters ahead.

Household consumption fell 0.5%, more than expected, under increasing pressure from the cost of living. And, unfortunately, things will get worse over the winter. Even though the government's energy price guarantee has been in place since the beginning of October and provides sizable support, bills have gone up significantly--by about 100% compared with a year earlier--and will squeeze out other spending. The impact is compounded by higher food price inflation, running at 16% in October.

Along with housing, food and energy make up most of poorer households' spending, which means that they are hit hardest by the current composition of inflation. In fact, in October, the poorest decile of households faced inflation at 12.5%, compared with 9.6% for the richest and 11.1% for the national average, according to the Office for National Statistics.

Short-Term Help For The Poorest, But Fiscal Policy Will Soon Turn Restrictive

If any lower-income households still have any savings left from the pandemic, they will likely be depleted by the end of the winter. By raising the minimum wage as well as benefits roughly in line with CPI inflation, as presented in the Nov. 17 budget, the government will provide meaningful support to those households. However, it will not be enough from altogether preventing a squeeze, in our view, partly because prices have been rising at increasing rates for about a year already and because we expect the composition of inflation to become even less favorable for lower-income households over the next quarters. The squeeze on spending is already evident in retail sales numbers that show a widening gap between volumes and values. In other words, people buy less, yet have to spend more.

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To offset the costs of support measures, notably the energy price guarantee, the government froze current income tax thresholds for longer, among other measures. Over time, as wages rise, this will increase the income tax burden on all employees, and its impact will persist even when inflation is back to target. This is one reason why we expect the economic recovery that will follow to be less dynamic. For those households that could just about afford to buy a home in recent years, higher mortgage costs will add to the squeeze.

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Although the labor market is now starting to show a softening and will weaken further, it is set to remain unusually resilient during the contraction ahead. Indeed, while vacancies have declined lately, the total number was still more than 400,000 above pre-pandemic levels at the end of August, and there was one open position on average for every person looking for a job. This is partly due to structural shortages and mismatches in the labor force since Brexit and the pandemic, which will take time to resolve. At the same time, it is a reason for our benign labor market outlook. We do not expect the unemployment rate to exceed 5%, for example, well below the 8% peak after the global financial crisis. Indeed, the solid labor market is a major reason our general economic outlook is not much worse. Even though households' income will be squeezed by double-digit inflation, unlike in a more "typical" recession, most households still will be able to rely on steady wage income. It's unlikely, in our view, that widespread forced selling of homes will occur as a result, but home prices are still likely to see a correction as mortgage affordability deteriorates.

Investment Conditions Remain Challenging

Although the reversal of most of the so-called mini-budget and the subsequent announcement of a new budget in November appears to have calmed markets, financing costs remain less favorable by recent historical standards. Combined with persistent uncertainty and low confidence, we are now also more pessimistic about investment growth. We no longer expect a business investment boom in the run-up to the expiration of the super-deduction scheme at the end of March next year. Housing investment is also set to suffer, in our view, faced with high construction costs and a weaker housing market outlook, in addition to higher funding costs.

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Not Much Further To Go For The Bank Of England

The Bank of England (BoE) will continue to face the challenge of finding the right trade-off between curbing inflation in the medium term without inflicting too much economic pain in the short term. Core inflation, the primary determinant of longer-term inflation levels, is running at 6.5% and remains a key concern, mainly because one of its key ingredients, wage inflation, at 6%, is showing no signs yet of abating. The persistence of high wage inflation will depend on pay agreements following ongoing and future industrial action. Having said that, inflation is now close to its peak, which we estimate at 12%. Declining rates of producer price inflation since late summer support this view. Output price inflation tends to lead to consumer price inflation.

At the same time, fiscal policy is now more restrictive and more in line with the BoE's inflation-curbing efforts. A deteriorated economic outlook and already tighter financing conditions will also help bring inflation down. On balance, we continue to expect the BoE to implement one more 50 basis point hike in February and then pause and reassess. This is well below market expectations, which see the rate at just under 5% on average in 2023. Incidentally, while the BoE itself stated in its November decision that it might have to take rates further than the current 3%, it also implied current market expectations were higher than what is required to bring inflation back in check, both in line with our assessment.

The BoE had delayed its quantitative tightening (QT) program while it intervened to stabilize bond markets during and following the market turmoil last September, just after the government's mini-budget was announced. But since then, it has successfully started auctioning off government bonds from its balance sheet to the tune of around £8 billion a month on average. This makes up just around 12% of the balance sheet for the first year and reflects the BoE's cautious and gradual approach to QT. In our view, this pace of tightening will gradually translate into moderately higher yields and complement the overall policy goal

Forecast Risks Abound On The Downside

Downside risks dominate our forecast. On a technical level, there is a great deal of uncertainty about the role of business inventories. We estimate that the buildup of inventories to extraordinarily high levels--restocking of depleted stocks after the pandemic--made up one-third of GDP growth in 2022. As these inventories are wound down, they will likely pull growth down 1.7 points in 2023, according to our estimation. However, the timing and magnitude are difficult to predict, and GDP outturns could change if a different profile materializes.

In the past, households have often proven more resilient than expected. While the lingering effect from the inflation shock will limit the rebound from the recession, there is a chance that the household recovery could be more robust than we currently expect. In this case, GDP growth could be more robust in 2024 and 2025 than we currently forecast.

Uncertainty about the development of the Russia-Ukraine war and its impact on global energy markets remains pronounced. And there is a risk that global and domestic financing conditions could deteriorate beyond what we currently expect, leading to worse outcomes. Finally, there is a question about how much the anticipated global recovery will be able to lift U.K. economic growth via trade against the background of Brexit frictions with the EU, which is still the U.K.'s most important trading partner.