EY ITEM Club Autumn Forecast

Is the economy ready to step up a gear?

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1.5%
GDP growth forecast for 2017
1.4%
GDP growth forecast for 2018
3%
Inflation to rise before the end of 2017

Forecast highlights

UK economy remains in low gear

Following a slowdown in the first half of 2017, the UK economy remained stuck in low gear over the summer, reflecting the squeeze on consumers’ real incomes and uncertainty over the Brexit negotiations. We suspect quarter-on-quarter GDP growth was running at around 0.3 - 0.4% in the third quarter (Q3) of 2017, compared to 0.3% in both Q1 and Q2.

Looking forward, it’s likely the economy will continue to struggle for momentum in Q4 2017 and early 2018. Consumer price inflation reached 2.9% in August and seems set to top 3% before the end of 2017, maintaining the squeeze on consumers. Furthermore, average earnings growth was just 2.1% in the three months to July, despite the unemployment rate falling to 4.3%, its lowest since 1975. There are few signs of a tightening labour market generating higher pay, and businesses are likely to remain cautious over investment in the near term, with the Brexit negotiations likely to progress relatively slowly despite Prime Minister Theresa May’s Florence speech.

GDP growth limited

Given all these factors, we expect GDP growth to be limited to 1.5% in 2017, slipping to 1.4% in 2018. However this masks an expected gradual pick-up in activity as next year progresses. Inflation is likely to fall back during 2018, ending the year at around 2% as the effects of sterling’s slide in late 2016 fade. This should bolster consumer purchasing power, while earnings growth should pick up gradually.

Brexit - transition agreement expected

Much depends on how the Brexit negotiations develop. We expect the UK and EU to make sufficient progress to agree a transition arrangement lasting at least two years, from late March 2019. Since this will have to be ratified across the EU, agreement essentially needs to be reached by October 2018. Progress towards a transition deal in late 2018 should support business confidence and a gradual pick-up in investment, helping GDP growth accelerate to 1.8% in 2019 and 2.0% in 2020.

Interest rates set to rise this year

The Bank of England’s Monetary Policy Committee (MPC) has recently become significantly more hawkish over UK inflation and diminishing spare capacity in the economy. While the Bank has previously hinted at a near-term interest-rate hike, which ultimately wasn’t realised, there seems to be more unanimity within the MPC this time around. What’s more, another failure to follow through on hawkish comments could undermine the Bank of England’s credibility.

As a result, we now think the Bank of England is more likely than not to raise interest rates from 0.25% to 0.50% before the end of 2017, probably in November. Given that interest rates have not risen since 2007, the MPC may well sit tight for a period after the initial hike to see how consumers and businesses respond. Specifically, we don’t see the MPC moving again until Q4 2018, when we believe an improving economy will see rates lifted to 0.75%.

Public sector pay gap

The Conservative’s loss of their majority in June’s general election result suggests that some of the public are fed up with austerity. his is likely to trigger a modest loosening of the purse-strings in November’s Budget, including a relaxation of the 1% cap on public sector pay. However, Chancellor Philip Hammond has repeatedly voiced his commitment to the fiscal rules established in the 2016 Autumn Statement, targeting a balanced budget by the mid-2020s. It’s also clear that he wants to keep some powder dry in case, at some stage, the economy takes a major hit from Brexit-related uncertainties.

Low-rev economy puts pressure on consumer businesses

by Mark Gregory, EY Chief Economist


UK economic growth remains below trend

While a formal Brexit is still 18 months away, the consequences of the referendum result are influencing UK economic performance. In particular, the lower value of sterling and the decline in business confidence – both at least partly attributable to the referendum outcome – continue to impact the economy. Consumer spending is slowing as real incomes come under pressure, while uncertainty appears to be inhibiting business investment.

With little change in the Government’s fiscal stance and exports adding only limited momentum, the overall effect is growth remaining below trend, with the UK economy appearing to grow at around 0.3 to 0.4% a quarter.

Brexit transition arrangement

As EY ITEM Club notes, the details of the basis for Brexit remain unclear, although the UK Government has made plain its desire for a transition arrangement during which the UK’s relationship with the EU would continue much as it does today. The latest forecast assumes a transition arrangement will happen and that the details will be clear by October 2018, creating more certainty and encouraging higher business investment in the later years of the forecast.

Interest rates – sharper tone for the Bank of England

The major change in the last few months has been the hardening of the Bank of England’s attitude towards an interest rate rise. In part, the Bank appears concerned over spare capacity in the UK economy, and hence the risk of inflation even after last year’s decline in sterling has worked through. Nevertheless, EY ITEM Club expects a relatively slow tightening after an initial interest rate increase of 0.25% in November, meaning there’s little impact on the overall forecast.

Economic growth remains subdued

The message for businesses remains similar to that after the summer forecast: the UK economy is stuck in a period of low growth compared to historic averages. The consumer sector remains under the most pressure with inflation, low wage rises, welfare cuts and a slow housing market all acting as drags on spending. Consumer and retail businesses are also dealing with major disruption from online in their sectors, and it may be time to undertake an in-depth review of the fit of their business models to the emerging environment.

Other key issues that all businesses should be assessing are:

  • Changes to the UK labour market as Brexit comes ever closer
    Anecdotal evidence of labour shortages has not yet been reflected in wage and employment data. But constant monitoring is essential to avoid being caught out.
  • Interest rate increases
    It does appear that interest rates will rise. Businesses need to be sure they can cope and that their financing is in place.
  • Political uncertainty
    The landscape has changed and the Conservative Party conference signalled a more interventionist role in energy prices and housing. Any continued slowdown may see more areas come under scrutiny. Businesses should continue to monitor how their operations might come into the spotlight and what the risks would be.

While the economy has not fallen off a cliff as some forecasts of Brexit’s impacts predicted, growth remains slow and risks are weighted towards the downside, with uncertainty around Brexit and the labour market. Confidence is fragile and adverse developments could create a momentum of their own. It would be sensible for businesses to include a downside case in their planning – namely a potential sharp slowdown after Brexit while the economy comes to terms with the changes.

Contact

EY - Mark Gregory

Mark Gregory

EY Chief Economist

EY have been sole sponsors of the ITEM Club for 25 years. It is the only non-governmental forecasting group to use HM Treasury's model of the UK economy. Our reports provide a detailed economic analysis and forecast of economic activity for the period ahead. They are independent of any political, economic or business bias.