A Royal lift

Back in November last year, the Bank of England (BoE) warned that the UK was facing the longest recession since records began. They suspected that the recession began in the summer of last year and expected this “mild” recession to persist until the first half of 2024. It was in this vein that I previously dubbed Andrew Bailey, Governor of the BoE, “Mr. Worry”. Indeed, balancing one of the most pronounced squeezes in living standards with the necessity to raise rates to quell potential longer-term price pressures is no easy thing to do. 

While the third quarter of last year did show the UK economy moderately contracting, the fourth quarter showed a slight increase. Thus, a recession was avoided (using the technical definition of two successive quarters of declines). Furthermore, the UK is estimated to have seen better momentum coming into this year with the economy growing by 0.4% in January and flatlining in February. Survey data is indicating that the modest expansion continued through March with early estimates for April showing an acceleration in activity. It is also worth bearing in mind that the level of industrial action seen over the past six months has also served to dampen activity in that period. 

A lot of this improvement can be attributed to the declining cost of energy, which has fallen to levels below the Russian invasion of Ukraine. So far household bills have been spared the worst of the crisis by the government energy support schemes and cap. As the year progresses, prices are expected to fall below the level of the cap. This means that some of the squeeze to household incomes will likely reverse later this year. The job market has remained resilient with businesses showing their desire to fill vacancies and willing to increase wages to do so. On the other hand, reports that food bank usage hit record highs highlights just how deep the squeeze in real incomes is for some households. Furthermore, credit card balances have increased over the past year, indicating that some households had to rely on credit to make ends meet.  

However, improving broader growth prospects in an inflationary environment is a double-edged sword. Inflation, as measured by the Consumer Price Index (CPI), proved stickier than expected in March with the annual rate remaining in double digit territory (10.1%) relative to expectations for it to fall just below this mark. Looking at the more “core” components, this remained at 6.2% on an annualised basis. Food prices rose a staggering 19.1% year over year, the fastest rate since 1977, with cheaper staples facing the largest increases. In addition, wage growth in February accelerated and was higher than anticipated. While the unemployment rate did rise moderately, this was a function of people (re-)entering the labour market. Business confidence* appears to have bottomed in November last year and has steadily increased since then. Taking this all together means the BoE faces difficult decisions over the coming months. 

Mechanically, inflation will start moderating from next month as the large energy increases of last year start to fade given the base effects. While inflation remains high, it is typically a lagging indicator as companies initially hedge some of their input costs and thus delaying some of the price increases. As both energy and food commodity prices have moderated and wage increases have been agreed, we are unlikely to see a repeat of similar magnitude in food costs. The effects of rising interest rates are yet to be fully felt by households who are due to re-mortgage over the coming quarters and businesses who are considering their investment plans in light of higher financing costs. This is likely to reduce demand for leisure activity overall. While job vacancies have declined, they still remain historically elevated indicating that we may see further increases in wages that are not in line with achieving the BoE’s inflation target. 

All in all, while some members of the BoE Monetary Policy Committee expressed their view that they had done enough to bring inflation back to its two percent target over the medium term; recent economic data means a further 0.25% rate hike on the 11^th of May is baked in. Economists consider a fall in energy costs as a tax cut for consumers and recent economic data is showing the merit of this adage. The risk is now that the BoE feels compelled to raise rates further in subsequent meetings, potentially bringing interest rates closer to 5%. As such, the language surrounding the next rate decision will be closely scrutinised. So, while the country cheers the coronation, the following week when Governor Bailey delivers the BoE assessment, he may give homeowners who are looking to re-mortgage this year a reason to turn from Mr. Cheerful to Mr. Miserable.    

* as measured by the Lloyds Bank Business Barometer.