Potential changes to the Northern Ireland protocol could also have a market impact. Regardless of one’s view of the protocol itself, the market fears that the outcome may be a ratcheting up of tensions between the UK and EU, and even though it is unlikely to come to this, could even lead to a trade dispute.
My view is that the UK economy is heading for a sharp slowdown. Latest data shows the economy, after falling 0.1% in March, contracted 0.3% on the month in April – and although the ending of test and trace depressed the GDP data by 0.5% that month, the indications are that the economy is losing momentum.
A technical recession is possible, where the economy suffers two successive negative quarters of growth, is possible but is not expected by the market. The picture is complex, as some parts of the economy are resilient, but many parts are already suffering because of the cost-of-living crisis. Sanctions against Russia are not helping the UK’s inflation picture.
The Bank of England (BOE) is now taking the right action. A tighter monetary policy and a looser fiscal stance is the right policy approach. But it is possible that monetary policy could be tightened more than the markets are currently discounting, and that as fiscal policy is eased, monetary policy will be tightened more. It would not surprise me if there is a 0.5% hike at the forthcoming Monetary Policy Committee meeting although my preference is for less.
Overall economic backdrop – rising inflation, softening growth
Our view on inflation remains that UK inflation is near to peaking, but will remain elevated for some time, and is expected to decelerate next year. This is also reflected in current market thinking that policy rates will continue to rise and peak in the first half of next year.
One concern is that there is broad based upward pressure on inflation across a large range of components. And it is still unclear where inflation will settle after it has decelerated. The BOE expects inflation to undershoot its 2% target in three years, but with inflation coming in higher than expected in the US last week, there are raised concerns in the market about medium-term inflation risks in the UK, too.
The annual rate of consumer price inflation reached 9% in April, with a 2.5% month on month increase. Labour markets are tight. As demand slows, product markets should not be tight.
Sanctions linked to the war in Ukraine could exacerbate the inflation outlook, but the risk is that with some countries continuing to buy Russian energy, this will likely prolong the war and in turn the negative impact of sanctions.
Fuel prices thus remain high and rising in the UK. In the US they recently reached an all-time high. High energy prices are normally a harbinger of future economic problems.
The economy is weakening as the cost-of-living squeeze hits. There are a number of components to this, relevant for the present policy debate, but in conflicting ways. A weakening justifies in my view an easier fiscal stance, but there are those who believe that if inflation is high fiscal policy should be kept tight. It also depends upon one’s view of whether there is any spare capacity, or an output gap.
Since the 2008 global financial crisis, the UK’s trend rate of growth has fallen significantly. The issue that is relevant for now is that it has raised the question as to whether the UK economy is at full capacity, with no output gap. Indeed, in its May Monetary Policy Report, the BOE believed that there was excess demand of 0.5%. If the economy is at full capacity, this may add to fears that any boost to demand through a relaxed fiscal stance could add to inflation.
This, though, is mitigated by signs demand may be easing, evidenced in recent soft monthly spending data. Also, while purchasing managers’ indexes (PMIs) are still above 50 (indicating expansion) they are softening. The composite PMI in May was 53.1 versus 58.2 in April so activity is not collapsing. With demand easing, and with the possibility that the economy faces downside risks, there is scope for fiscal policy to ease, without triggering inflation worries.
The consumer slowdown and declining savings ratio
The latest news on consumer spending, from the British Retail Consortium showed a declining trend from January. The year-on-year data reported for May is not adjusted for inflation and was down 1.1%. Like-for-like sales were down 1.5% in May, lower than the three-month trend of -1.1%.
Retail sales volumes were up 1.4% in April vs -1.2% in March. Retail sales are 4.1% higher than in February 2020, but in the last three months, volumes fell 0.3% versus the previous three months.
During the pandemic, attention focused on the large rise in the savings ratio, but this is now starting to correct. The savings ratio was 6.0% in 2019 (Q4). It peaked at 23.9% in 2020 (Q2) and has trended down since, to 6.8% in 2021 (Q4). After the Global Financial Crisis, the savings ratio rose but less dramatically than during Covid, but it stayed at the higher ratio of around 11% for longer, around six quarters. The sharp fall in the savings ratio now may suggest greater calls on people’s income now because of the cost-of-living crisis.
This is not surprising: data from the House of Commons Library suggested that by this autumn, and compared with 2019-20 (last official data), the lowest income decile households would be £1,190 worse off from fuel costs alone per year, with average households £1,526 worse off. Food costs are also surging.
There has also been an increased focus in the markets on the tight labour market and it has added to concerns about whether the economy is hitting capacity constraints, in turn adding to worries about inflation. Unemployment is low, employment is high. But attention has turned to the high rate of inactivity (those not working and not looking for work) and the rise in vacancies.
Notably, there has been a post-pandemic rise in inactivity for those under 24 and over 50, but it has also drawn attention to the large numbers on disability and other such benefits. Meanwhile, the numbers of immigrants working in the labour force continues to rise, reaching 19%, according to a recent report from the Spectator. The economics of this are twofold: will it lead to upward pressure on wages? And is it a sign of capacity constraints and if so, will this constrain growth and add to future inflation concerns?
Where now for sterling?
Previously I have cited the risk of a sterling crisis if a tightening monetary policy was combined with a tight fiscal stance, in which case the markets may see a weaker pound as the shock absorber.
Yet the recent shift to an easier fiscal stance should help mitigate the downside pressures on sterling, but given all the other issues noted here the market may be tempted to test the downside for sterling.
A common view expressed in the market is that sterling looks vulnerable because the UK faces high domestic inflation, a tight labour market that may add to inflation and weak output, with policy tightening likely to add to economic weakness.
Although I think sterling is cheap, the combination of policy, political and economic challenges suggests that the risks for sterling are to the downside in the near term.
What is the right policy mix?
I think a tighter monetary policy to fight inflation and a looser fiscal stance to address downside economic risks is the right approach.
The inflation shock is supply-driven (with the BOE attributing 80% of the inflation shock to this), monetary driven but not demand-pull driven. To squeeze inflation the argument is to tighten as soon as possible, and to tighten both monetary and fiscal policy simultaneously.
The arguments in favour of tightening fiscal policy are: if you believe the economy is already at full capacity with no spare capacity and if you do not believe domestic demand is slowing.
However, at Her Majesty’s Treasury the fear is that the looser fiscal stance could exacerbate inflation pressures. If similar thinking prevails at the BOE then it is possible that monetary policy could be tightened more aggressively, sooner. Currently monetary policy still appears loose, with policy rates at 1% and inflation at 9%.
Please note, the value of your investments can go down as well as up.
