1. Economic backdrop

1.1 Improving outlook

In November 2022, the Bank of England was forecasting the “longest recession since the 1930s”, with gross domestic product (GDP) expected to fall from Q3 2022 all the way through to mid-2024. However, recent GDP data suggests that economic activity has been more stable than previously expected. UK GDP was flat in Q4 2022, having fallen 0.2% in Q3. The UK has thus far avoided two consecutive quarters of negative growth, the commonly used definition of a recession.

Looking ahead, survey results from the purchasing managers’ index (PMI)—comprising leading economic indicators, produced by Standard and Poor’s (S&P) Global in partnership with the Chartered Institute of Procurement and Supply (CIPS), which track business activity and tend to correlate with GDP—suggest that the risks of a recession in 2023 have eased. The February composite PMI—encompassing the manufacturing and service sectors—suggests that, following a six-month period of decline, the majority of businesses are now reporting expanding activity. The survey results signal “the strongest increase in private sector output since June 2022” according to S&P Global/CIPS.

Improved prospects for the economy appear to be linked to the recent fall in wholesale energy prices. As reported by the Financial Times, European gas prices have fallen by as much as 85% since August 2022, back to levels last seen in 2021 before Russia invaded Ukraine. As well as helping reduce input prices costs for businesses, lower energy costs allow for an increase in consumption by households. The Bank of England cited this as a key reason for upgrading its growth forecasts in its February 2023 ‘Monetary policy report’.

Falling energy costs are expected to contribute to a rapid fall in inflation over the course of 2023. The 12-month rate of consumer price index (CPI) inflation was 10.1% in January, down from 11.1% in October 2022, and the Bank of England expects it to fall to 4% by the end of the year.

The prospect of inflation falling in this way raises the possibility that interest rates may be at, or close to, their peak. From December 2021 to its most recent meeting in February 2023, the Bank of England’s Monetary Policy Committee (MPC) has raised interest rates for 10 meetings in a row, from a historic low of 0.1% to their current level of 4.0%, in an attempt to return inflation to its target of 2.0%. However, in comments reported in the Financial Times, the Bank’s governor, Andrew Bailey, has recently cautioned “against suggesting either that we are done with increasing Bank rate, or that we will inevitably need to do more”. These comments represent a shift from the Bank’s previous position that further increases would be required.

The combination of factors cited above appears to have reduced the risk that the UK will fall into recession in 2023. For example, the National Institute of Economic and Social Research (NIESR) recently forecast that the UK economy would grow by 0.2% in 2023. Nevertheless, a contraction remains the base-case scenario for most forecasters. According to Consensus Economics—an international economic survey organisation—the average forecast, as expected in February, is for the UK economy to contract by 0.6% in 2023, up from the 1.0% contraction expected in January.

1.2 Ongoing cost of living difficulties

In its ‘UK economic outlook: Winter 2023’, NIESR argued that even if the UK did avoid a ‘technical recession’ in 2023, it would still “feel like a recession for many”, with the cost of living crisis squeezing disposable income. This is because even though energy prices have decreased and interest rates may not reach as high as previously expected, households would still face costs for essential goods which were significantly elevated relative to their pre-pandemic norms.

For example, the Institute for Fiscal Studies (IFS) noted in its report ‘The cost of living crisis: A pre-budget briefing’ that, as of January 2023, the annual inflation rates for ‘gas and electricity’ and ‘food and non-alcoholic drinks’ were 90% and 17% respectively. The IFS also noted that this represented a significant challenge for lower-income households that spend a disproportionately large share of their income on those goods relative to better-off households. NIESR calculates that there will be seven million UK households, approximately one in four, that are “unable to meet in full their planned energy and food bills from their post-tax income in 2023–24”.

Better-off households will be more significantly impacted by mortgage rate increases, as outlined by the IFS:

Across all households with a mortgage, we estimate that an increase in mortgage rates from 2% (the typical 2021–22 rate) to 5.8% (in line with Bank rate increases since 2021–22) would on average reduce incomes after mortgage payments by 7.5%. This rises to 10% for those aged under 45, who tend to have larger outstanding mortgages.

However, the prevalence of fixed-rate mortgages will ensure that the impact of increased mortgage costs is rolled out gradually.

2. Fiscal backdrop

2.1 Lower than expected borrowing

Public sector borrowing in the financial year to date has come in much lower than the Office for Budget Responsibility (OBR) had previously forecast. In its ‘Commentary on the public sector finances: January 2023’, the OBR stated that borrowing in the first 10 months of 2022/23 was £116.9bn, £30.6bn lower than expected. This equates to 1.2% of GDP, an unusually large forecast error. In its ‘Forecast evaluation report: January 2023’ the OBR notes that, since it was established in 2010, its median absolute forecast error for in-year borrowing forecasts has been 0.4% of GDP.

As outlined by the IFS, lower than expected energy prices and interest rates are a significant cause of the lower than expected borrowing figures. This is because they reduced the cost of the government’s energy subsidy scheme and interest on government debt respectively. Higher than expected tax revenues also made a significant contribution.

The IFS cast doubt on the extent to which these factors will durably improve the public finance position over the medium term. Savings to the energy subsidy scheme improve the short-term picture only, as the scheme is due to expire. It is possible that lower debt interest payments will persist and that the ‘tax-richness’ of the economy has increased, but this is uncertain. As such, the IFS suggests that “the case for permanent tax cuts or spending increases that are not offset elsewhere is no stronger now than in the autumn”.

2.2 Public spending pressures

On 23 February 2023, the Institute for Government published a spring update to its public services ‘Performance tracker 2022/23’. The report suggested that the measures announced in the 2022 autumn statement had eased some pressures, but that “services still do not have sufficient funding to return to pre-pandemic performance levels” which in most cases were “already worse than when the Conservatives came to power in 2010”. Furthermore, recent industrial disputes are likely to exacerbate these funding pressures. The report suggested that “without further funding injections, an increased share of budgets will need to be spent on higher pay awards” if public sector strikes are to be ended.

In addition to the funding challenges faced by domestic public services, there is also pressure for increased defence spending as a result of a perceived increase to the security risks faced by the UK in the wake of Russia’s invasion of Ukraine. In the 2022 autumn statement, the government stated that it “recognises the need to increase defence spending to meet the threats we face, and will consider this as part of an update to the integrated review”. As noted by IFS analyst Ben Zaranko, the significant increase in health spending over the post-war era was offset by a significant decrease in defence spending—the ‘peace dividend’. Mr Zaranko has argued it could create considerable fiscal challenges elsewhere if both were to rise at the same time.

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Cover image by Carlos Delgado on Wikimedia Commons.