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UK economic outlook: navigating the endgame

  • Benjamin Nabarro

Published on 10 October 2024

Growth has been better than expected this year, but the UK’s recovery is not yet secure. Structural changes will require reform, not just investment.

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Key findings

1. The UK’s economic performance over the past two decades is hard to describe as anything other than a policy failure. Productivity growth has been dire – with per-worker growth over the past decade the weakest on average since at least 1850. The innovative engine behind the UK economy seems to have stalled. In 2014, a little under 6% of all firms in the UK (14,000) were ‘high-growth firms’ – employing at least 10 people and growing their headcount by more than 20% per annum for three years running. This has fallen to just under 4% now. Macroeconomic resilience also seems to have suffered as low growth, low investment and weak income growth have all fed back into one another.

2. The growing global challenges surrounding ecological and geopolitical transition should add to a sense of urgency. These imply further economic headwinds to growth in the years ahead, alongside heightened volatility. More physical investment will be required to ameliorate these effects. But this does not constitute a strategy for addressing the UK’s existing growth shortfall. High debt levels, a structural external financing gap and elevated rates volatility mean the stock of outstanding debt is a growing vulnerability. In this sense, the UK likely finds itself in a worse position than the US or the Euro Area.

3. The UK needs to lift growth despite these growing challenges, in the context of limited policy space. Here we think the focus should be on boosting intangible and ICT investment, alongside broader efforts to improve diffusion from the technological frontier. Both growth and resilience will need to be areas of focus. The UK, as a small open economy, remains particularly exposed to future shocks. Efforts to bolster resilience, as well as better coordinating monetary and fiscal policy, will be crucial to navigating these shocks better in future. In our view, without countercyclical ‘burden sharing’ between monetary and fiscal policy, structural efforts to lift trend growth are unlikely to be successful.

4. The cyclical outlook we present here is one of near-term ‘sogginess’ and medium-term optimism. Globally, we think the near-term outlook is likely to remain somewhat weak. Supportive factors for demand – in particular, significant fiscal support – are beginning to fade. Continued structural uncertainties in China – recent stimulus notwithstanding – remain a headwind across Europe. And US growth exceptionalism does appear to be gradually fading as the impact of tighter monetary policy feeds through. We expect global activity to fall back in the second half of this year. This implies fading external support for UK growth as we move into 2025. External inflationary influences are also likely to continue to fade. 

5. The UK economy has surprised to the upside since the start of 2024. We now expect real GDP growth of 1.0% this calendar year, compared with a forecast of just 0.1% back in January. But these welcome improvements are not yet indicative of a secure economic recovery. Instead, they primarily reflect transient improvements in capacity as energy prices have fallen back. For now, the outlook for the core domestic demand engines for the UK remains subdued. A sharp improvement in real incomes since the start of the year has not yet translated into stronger consumer spending. Firm sentiment and investment intentions have improved but remain on the defensive side. And public consumption is likely to prove constrained. We expect growth to remain positive but weak in the near term, with real GDP increasing by 0.7% next year.

6. A procyclical monetary policy approach risks slowing the recovery in our view. Structural changes have slowed the transmission of monetary policy into economic activity. The effects of higher interest rates may become more material as many parts of the economy are forced to borrow once more; around half of the cumulative effect of monetary policy is still to be felt. This will suppress demand, just as the supply side of the economy begins to recover. Better news in the latter case reflects lower energy prices, and rebalancing between labour and non-labour inputs in production. This is cause for optimism, although monetary headwinds will make it difficult to capitalise immediately. We expect growth to accelerate markedly through 2026 and 2027 as monetary and fiscal constraints are eased.

7. The outlook for the household sector should improve modestly in the months ahead, although household sentiment remains somewhat defensive. Much will depend on developments in the household saving rate. The ‘cash’ saving rate – i.e. excluding the imputed equity of pension funds – has climbed from 3.4% just before the pandemic to around 8% now. This has been pushed higher by a combination of uncertainty, consumption smoothing and balance sheet impairments. In the months ahead, we think the saving rate may come down modestly as uncertainty dissipates – although we expect the rate to remain elevated as households overall are significantly less well off now than before the pandemic. We expect private consumption to increase by only 0.6% in 2025, compared with 1.5% in the Bank of England’s baseline estimate. The outlook for firms should improve as supply growth picks up and costs decline, though any gains will come from a weak base. Business investment should recover gradually as interest rates fall.

8. Excess labour demand – present through 2022 and 2023 – has now been eliminated. We think most recent data suggest the labour market is continuing to loosen. Vacancies have continued to trend down over recent months, if perhaps at a more moderate pace than last year. Private employment dynamics also look weak, at least according to the PAYE data. As public sector employment growth slows, we think the unemployment rate will increase to 4.9% next year and 5.3% in 2026. The risks here seem broadly balanced, although a flattening in the Beveridge curve would, if anything, imply a faster pass-through from lower vacancies into higher unemployment from here. We expect a modest loosening of the labour market to weigh on wage growth and consumer confidence into 2025.

9. The UK’s inflation process over recent years has been primarily ‘conflictual’ in that high wage growth and services inflation both reflect efforts to make up for large losses associated with an adverse terms-of-trade shock. This, we think, has contributed to sticky wage and services price inflation over recent months. But increasingly we think there are signs that these effects are beginning to fade, with the real income loss associated with the shock now having been more than fully absorbed. Evidence of further ‘agitation’ around either inflation or nominal wage growth seems limited, and confined to a few specific quarters. And forward expectations for both wages and prices are now broadly consistent with the inflation target. The natural decay in the UK’s inflation processes primarily reflects the relatively high ‘cost of conflict’ rather than the demand-destructive impact of higher rates. Inflation seems to have broadly returned to target without much direct input from monetary policy. To the degree that the latter now weighs on demand and slack, we expect to undershoot the inflation target through 2026.

10. The Monetary Policy Committee (MPC) remains in an inflation-averse state of mind. Having cut rates for the first time in August, we expect the committee to ease policy only gradually over the coming months as evidence around inflation continues to accumulate. However, if the labour market does loosen through the first half of next year, we think that is likely to signal the committee should pick up the pace. In our view, a continued focus on the upside risks around inflation, while understandable, is increasingly inappropriate. We expect the MPC to cut rates into accommodative territory through 2025–26 as policy refocuses on the risks around the labour market, and monetary policy is forced to correct for a procyclical monetary and fiscal stance through 2023 and 2024. 

11. After two decades of stagnation, change is needed. The outlook is for a period of near-term sogginess, followed by a more robust cyclical acceleration as supply-side improvements continue to materialise. This may provide a window of opportunity. Already, in the past decade, the gap between what the UK economy can support, and what has societally been promised, has widened. This is combined with the potential for an intermittently binding external liquidity constraint that also poses more acute risks. In a context of growing international rates volatility, the UK does not have time to spare.