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Economic Research: U.K. Economic Outlook Q3 2024: A Cooling Labor Market Paves The Way For Rate Cuts

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Economic Research: U.K. Economic Outlook Q3 2024: A Cooling Labor Market Paves The Way For Rate Cuts

Falling inflation, monetary policy easing, and improving terms of trade should help the U.K. economy rebalance over the next two years and return to potential growth, absent any other shocks. Indeed, the year started off strong for the U.K. economy. Consumers are expected to return to shops as their purchasing power recovers and companies will continue ramping up investments, backed by falling input and borrowing costs.

However, the labor market is easing, no longer just through falling job vacancies but also through job losses. This is keeping demand in check. Although this should help further control inflation, especially in the services sector, where it has remained high this year, it may make it harder for the Bank of England (BoE) to achieve a soft landing.

The BoE will also have to consider the 12-18 month time lag between any rate cuts and their effects on the economy when starting to ease. Overall, we believe a gradual approach to rate cuts is most likely, in particular due to the uncertainty regarding both the persistence of past supply shocks on inflation and the outlook for long-term economic developments.

The U.K. Economy Benefits From Improving Terms Of Trade And The Receding Impact Of Higher Interest Rates

The U.K. economy started 2024 on a strong footing,   with GDP rebounding by 0.6% in the first quarter, more than offsetting the decline in second-half 2023. leading us to revise our forecast upward for this year to 0.6% from 0.3%. Improving terms of trade are helping, with net trade the largest contributor to GDP growth, as imports contracted more than exports.

Investments were also strong, making up nearly half of the increase in activity, which suggests the effects of past interest rate rises is starting to fade. This was particularly visible in the construction sector, with households' residential investments starting recovering after five quarters of contraction and companies increasing their investments in buildings and structures. Adding to that, a clearer policy path in the U.K. might offer a more business friendly environment than it has been in the years following the Brexit referendum--especially in the face of high policy uncertainty in other advanced economies.

Chart 1

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The Labor Market Is Slowing, And Consumption Is Still Subdued

Consumer demand remains muted,   with just a 0.1% increase in first-quarter 2024 despite a recovery in purchasing power. Demand fell short of its pre-pandemic peak, with retail sales posting another fall in April. Higher interest rates and a slowing labor market may be the main reason why households' savings rate have increased since mid-2022, reaching 10.5% by the end of 2023.

Chart 2

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Chart 3

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The pace of disinflation is affecting demand too.   Headline inflation just reached the BoE's target of 2% in May, but this is mainly linked to a falling energy bill and less dynamic prices for food and non-energy goods. While this suggests goods prices are normalizing, services prices continue to rise quickly--at 5.7% year over year in May. Wage increases--the main drivers of those underlying price pressures, at 5%-6% year over year--are falling only slowly and still putting pressure on prices. As a result, we expect inflation to be marginally higher in 2024 (2.8%), before receding to 2.4% in 2025.

Chart 4

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Rising labor costs are increasingly impairing companies' hiring,  as are high borrowing costs and weak consumer demand all affecting their margins. The U.K. labor market is cooling faster than those in the U.S. and eurozone, with rising unemployment attributable to higher redundancies as opposed to an unmet increase in labor supply. Less-dynamic employment expectations point to less resilience in employment. We now expect unemployment to peak at 4.6% in 2026.

Chart 5

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On balance, household spending should be more dynamic in the second half of this year despite a cooling labor market,   as real incomes continue to recover thanks to lower price increases. Higher unemployment will feed through to lower salary gains and less price pressure. Consumers already feel more upbeat about their financial situation according to confidence surveys, notwithstanding job losses. This has helped shape the rebound of housing market activity as mortgage rates started to fall in the first quarter.

The BoE Will Cut Rates Gradually To Manage Uncertainty

Stronger growth than expected in first-quarter 2024 convinced the BoE to keep rates stable in June. Inflation might have hit 2% in May, but it's still too early for the BoE to claim victory since service prices remain elevated and pay growth is well above productivity gains. However, the expected slowdown in employment and a lack of recovery in consumer demand is likely to put the BoE in a good position to cut rates in 25 basis point (bp) increments from August. We expect 75 bps of cuts this year and 125 bps in 2025. This is for three reasons:

The BoE's starting point is high.   At 5.25%, the base rate is about 200 bps higher than the estimated neutral rate of 3.0%-3.5%. This means monetary policy will remain restrictive well after the first rate cuts (until 2026, according to our forecasts).

Monetary policy needs to be forward-looking, accounting for the 12-18 month lag.   We estimate that, once reflected in financial markets, rate changes take about 18 months to be reflected in economic activity and 12 months in prices. In other words, the BoE would theoretically need to cut rates to their neutral level a year ahead of achieving its target, which we expect in 2026.

Chart 6

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In our view, gradualism seems appropriate in the face of uncertainty.   First, like other central banks, the BoE is particularly data-dependent due to the supply nature of current inflationary stress. It can only observe the pass-through of those mostly external shocks in a backward-looking manner. While the immediate effects of the latest energy and food price shocks have dissipated, it remains unclear how long the indirect impacts will last--notably on services prices. Second, there is uncertainty about the impact of rate cuts in a soft-landing scenario. Previously, cuts have mostly occurred in a crisis context, which means they might not have been as powerful at propping up economic activity as they would be in the current growth outlook. Finally, there is uncertainty around the neutral rate level, notably because potential growth might be different than what it was before Brexit and the pandemic. Amid the current rebalancing of economic growth, the lack of clarity on the situation suggests a gradual approach to monetary policy might be the best way to assess rate cuts' impact on inflation.

S&P Global Ratings' U.K. economic forecast, June 2024
(%) 2022a 2023a 2024f 2025f 2026f 2027f
GDP growth 4.3 0.1 0.6 1.2 1.7 1.7
Household consumption 5.0 0.3 0.3 1.4 1.7 1.8
Government consumption 2.3 0.5 1.8 1.2 1.2 1.3
Fixed investment 8.0 2.2 1.2 1.6 2.5 2.2
Exports 9.0 (0.5) (0.2) 2.6 2.9 2.9
Imports 14.6 (1.5) (1.2) 3.1 3.1 3.0
CPI inflation 9.1 7.3 2.8 2.4 2.1 2.0
CPI inflation (Q4) 10.7 4.2 2.7 2.3 2.0 2.0
Unemployment 3.9 4.0 4.4 4.6 4.4 4.4
10-year government bond 2.3 3.9 4.0 3.6 3.5 3.5
Bank rate (EOP) 3.3 5.3 4.5 3.3 3.0 3.0
Exchange rate ($ per £) 1.2 1.2 1.3 1.3 1.3 1.3
Source: Office of National Statistics, Bank of England, S&P Global Market Intelligence, S&P Global Ratings (forecasts). a--Actual. f--Forecast.

This report does not constitute a rating action.

Senior Economist:Marion Amiot, London + 44(0)2071760128;
marion.amiot@spglobal.com

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