The outlook for the UK economy is challenging. It has hardly grown since last spring. In the near term, lower energy prices and rising wages should help alleviate the cost-of-living squeeze, while the fiscal support in the Spring Budget should provide a modest boost. However, the economy has yet to feel the full impact of monetary tightening.
The Bank of England (BoE) intends to pause its rate hiking cycle soon, but further increases in interest rates may still come if domestically generated inflationary pressures do not ease. High UK mortgage rates will continue to weigh on housing market activity, and households that need to refinance will face a higher mortgage interest burden.
Excess savings accumulated during the pandemic have provided a cushion to household consumption, but the value of the savings is being eroded by inflation. BoE data shows households’ net financial wealth relative to income is lower than in the pre-pandemic period.
Only a trickle of credit
BoE credit conditions surveys show that credit availability was low for small and medium-sized enterprises. Credit was reported to be particularly limited for property investment and construction firms. At the same time, insolvencies have continued to rise, mainly among small companies. They are expected to increase further in 2023.
The availability of secured and unsecured lending to households has declined, reflecting both perceptions of a deterioration in the economic outlook and reduced risk appetite. With interest rates remaining high and the UK’s growth outlook poor, we expect lending standards to remain tight and borrowing appetite from businesses weak.
Fortunately there are signs of alleviating inflationary pressure: supply chains are easing, energy prices are softening, and survey results point to weaker pricing power as companies face lower demand and intense competition.
At the same time, private sector wage growth has started to lose momentum. Yet labour supply remains restricted, and labour inactivity due to long-term sickness is unlikely to be resolved soon given the impaired public health system.
This structural weakness in supply means that, despite the UK’s meagre economic performance over recent quarters, a risk remains that inflation does not fall as fast as the BoE is expecting. In that scenario, given concerns about second-round inflationary effects, the BoE might have no choice but to resume tightening.
BoE set for a pause
As credit standards tighten, the buffer from excess savings shrinks and consumers grow more cautious, we believe growth will continue to stall or weaken. In the near term, with monetary policy becoming more restrictive and inflationary pressure starting to ease, we believe the BoE is more likely to pause its tightening cycle.
In the medium term, we expect term premia to rise given the outlook for large fiscal borrowing against the backdrop of active Gilt (government bond) sales by the central bank, as well as the rising risks of inflation not easing as quickly as desired.
While fiscal credibility is unlikely to resurface as an issue in the near term, it is uncertain whether the eye-watering borrowing needs will see sufficient investor demand over time.
At the same time, the healthy funding status of pension funds should support liability-hedging demand as Gilt volatility has receded from its spike in September amid concerns over the then government’s budget plans.