Key Takeaways
- The U.K. economy will remain weak in 2024, with GDP growth of just 0.4%, as high price inflation continues.
- The labor market is tight, resulting in persistently high wage growth. Brexit and the COVID-19 pandemic have weighed on labor supply, and vacancies remain 40% above their long-term average.
- A tighter labor market means that monetary policy will need to remain restrictive for longer to get the inflation rate back to the 2% target. We don't expect the Bank Of England to cut rates before the second half of 2024.
The U.K. faces yet another year of economic weakness in 2024, with GDP growth of just 0.4%, as interest rates remain restrictive for an extended period. Even though headline inflation has now eased markedly, core price pressures persist. This has taken its toll on households' purchasing power. At the same time, higher interest rates are incentivizing consumers to save more and delay major purchases and investment decisions.
The labor market remains tight, encouraging dynamic wage increases. The U.K.'s exit from the EU single market, an increase in the number of the long-term sick, and workers' changing job preferences due to the pandemic have all contributed to this. The tightness means that monetary policy will have to remain restrictive for longer to return the inflation rate to 2% on a sustainable basis. We now expect the Bank of England to keep rates unchanged until the start of the second half of 2024.
The Purchasing Managers' Index points to a small contraction in economic activity in the fourth quarter of 2023, following stagnation in the third quarter. The manufacturing sector has been contracting since the start of the year, partly due to a readjustment of global supply amid weaker trade. In contrast, weakness in services activity only became pronounced over the third quarter.
Structural Changes Point To A Tighter Labor Market
While monetary policy in advanced economies appears to be somewhat synchronized, inflation in the U.K. has remained much higher than in the eurozone and U.S. (see chart 1). Initially, this was linked to a more pronounced surge in energy prices, but now it appears to be the result of persistent high wage growth.
Like elsewhere, energy inflation now makes a negative contribution to overall inflation; upstream inflation, that is, the Producer Price Index and inflation of nonindustrial goods prices, has also turned negative; and food price inflation is still elevated but coming down. Sticky inflation is mostly visible in services, with prices increasing by 6.6% in October 2023, just a little below the July high of 7.4% (see chart 2).
Chart 1
Chart 2
Wage growth is persistently high
This explains why inflation is taking more time to recede in the U.K. than in the U.S. and the eurozone. Inflation expectations, productivity growth, the unemployment gap, and previous wage growth do not entirely explain wage increases in the U.K. There is an unexplained residual amount of around two percentage points, according to the Bank of England's Monetary Policy Committee member Johnathan Haskel (see chart 3). This suggests that past models likely underestimate labor market tightness. When the labor market is tight, wage bargaining power is greater, making a wage price spiral more likely to take hold as inflation expectations increase (see chart 4).
Chart 3
Chart 4
Brexit has made the labor market tighter
By exiting the EU single market for goods and people, the U.K. introduced more friction and inefficiencies into its labor and product markets, giving domestic workers more bargaining power. At the same time, investment has remained low amid uncertainty following Brexit, potentially incentivizing firms to hire more staff instead of increasing their capital. An increase in the share of labor in gross value added since 2016 also seems to reflect these dynamics.
Admittedly, net immigration has remained high even though fewer EU workers are now part of the U.K. labor market. Yet the skill set of the non-EU immigrants is different and their participation in the labor market is lower. Many are students or refugees. Consequently, immigration does not necessarily help fill the gaps in industries where the workforce is lacking.
The COVID-19 pandemic has also weighed on U.K. labor supply
Since the start of the pandemic, the health system has been running at capacity, leading to a rising number of potential workers waiting for treatment. This has led to a steady rise in the number of the inactive long-term sick, and explains why the share of employed 16-64 year-olds has yet to recover to pre-pandemic levels, despite more women entering the labor force and more workers retiring later (see chart 5). In addition, the pandemic may have affected workers' job preferences, potentially making it harder for some sectors, like restaurants, to hire staff.
Chart 5
Vacancies have been falling, but remain 40% above their long-term average
This is especially true of the services industry, and is another reason why wage growth is still dynamic, particularly in this industry. The sectors under more strain--health, accommodation, recreation, and education (see chart 6)--also show some of the highest inflation rates.
Chart 6
Interest Rates Need To Be Higher For Longer To Reach The Inflation Target
A tighter labor market means that monetary policy will have to remain restrictive for some time to get the inflation rate back to the 2% target on a sustainable basis. We now expect the Bank of England to keep its rates unchanged until the start of the second half of 2024.
The mismatch between skills and job opportunities is now greater than before Brexit and the pandemic as a result of the new demographics of the U.K. labor force. As a result, the nonaccelerating inflation rate of unemployment--the rate at which inflation stays stable--is likely to be higher now than before Brexit and the pandemic. Put differently, a greater fall in job creation is needed to reach the same 2% inflation target.
Higher rates are already dampening demand
Borrowing costs have risen the most for firms (see chart 7), leading to a fall in investment in the third quarter. House prices are falling as housing has become less affordable. At the same time, real income gains are now translating into more savings as consumers postpone consumption (see chart 8).
Chart 7
Chart 8
About half of the impact of monetary policy has yet to feed through to the real economy
After a decade of low rates, households and firms remain somewhat sheltered from higher rates as they have extended the maturity dates of their loans, albeit less so than in other European countries.
Adding to that, higher borrowing costs only really start to bite once inflation and wages have come down. It takes up to a year for inflation to fully reflect the impact of rate hikes, and up to two years for the labor market and GDP to adjust (see Cesa-Bianchi et al., 2019).
Real rates are now turning positive as inflation recedes (see "Economic Outlook U.K. Q4 2023: High Rates Keep Growth Muted," published on Sept. 25, 2023). We therefore expect the monetary impact to strengthen in the coming year, weighing on investment, job creation, and consumption.
Table 1
| U.K. economic forecasts | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (%) | 2021 | 2022 | 2023 | 2024 | 2025 | 2026 | ||||||||
| GDP | 8.7 | 4.3 | 0.5 | 0.4 | 1.5 | 1.6 | ||||||||
| Household consumption | 7.4 | 5.2 | 0.4 | 0.3 | 1.6 | 1.8 | ||||||||
| Government consumption | 14.9 | 2.5 | -0.1 | 1.4 | 1.2 | 1.2 | ||||||||
| Fixed investment | 7.4 | 7.9 | 2.3 | -1.9 | 3.2 | 2.7 | ||||||||
| Exports | 4.9 | 8.6 | -0.6 | 2.0 | 3.2 | 3.0 | ||||||||
| Imports | 6.1 | 14.1 | -1.3 | 2.1 | 3.8 | 3.2 | ||||||||
| CPI inflation | 2.6 | 9.1 | 7.3 | 3.0 | 2.2 | 2.0 | ||||||||
| CPI inflation (Q4) | 4.9 | 10.7 | 4.3 | 2.9 | 1.9 | 2.0 | ||||||||
| Unemployment rate | 4.5 | 3.7 | 4.2 | 4.6 | 4.3 | 4.2 | ||||||||
| 10-year government bond | 0.7 | 2.3 | 4.0 | 4.1 | 3.4 | 3.3 | ||||||||
| Bank rate (end of period) | 0.17 | 3.25 | 5.25 | 4.5 | 2.75 | 2.5 | ||||||||
| Exchange rate (US$ per £) | 1.38 | 1.23 | 1.25 | 1.28 | 1.37 | 1.38 | ||||||||
| CPI--Consumer Price Index. Sources: Office for National Statistics, Bank of England, S&P Global Market Intelligence, and S&P Global Ratings (forecasts). | ||||||||||||||
Related Research
- Economic Outlook U.K. Q4 2023: High Rates Keep Growth Muted, Sept. 25, 2023
External Research
- Cesa-Bianchi A., Thwaites G. And Vicondoa A. (2019), Monetary Policy Transmission in the United Kingdom: A High Frequency Identification Approach
This report does not constitute a rating action.
| Senior Economists: | Marion Amiot, London + 44(0)2071760128; marion.amiot@spglobal.com |
| Boris S Glass, London + 44 20 7176 8420; boris.glass@spglobal.com |
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