UK Reaction: Headwinds to growth should caution MPC

UK GDP growth posted another disappointment in August. Despite signs of an improvement in mobility on the month GDP rose by just 0.4% - short of the consensus 0.5% and below our forecast of 0.7%. August’s unexpected drop in retail sales – down 0.9% - clearly had an impact. Moreover, July’s preliminary estimated GDP rise of 0.1% was revised lower to -0.1%, with manufacturing output scaled sharpy lower to -0.6% m/m from flat in the first estimate. However, this was at least in part a reaction to substantial upward revisions to April and June’s GDP, that left Q2 GDP now seen as rising by 5.5% (from 4.8%) initially. We have lowered our forecasts for growth in H2, considering growth of 1.3% most likely for Q3 GDP and around 1% for Q4. However, following a stronger H1, this would still leave UK GDP growth just below 7% (6.9% for the year as a whole). This is softer than the BoE August forecast of 7.25%. However, more pertinently the BoE will have to consider the scale of deceleration in economic activity – particularly in the light of growing headwinds to future growth, before deciding how much to slow the economy further by tightening monetary policy.

A rise in GDP growth in August was driven by industrial and services output. Industrial production posted a solid 0.8% rise in August (beating the 0.2% consensus), but only after July’s solid 1.2% was revised lower to a more meagre 0.3%. Much of this was driven by manufacturing which rose by 0.5% (consensus unchanged), but after July’s output was revised down to -0.6% (from 0.0%). Industrial production was further spurred by large increases in output from oil & gas extraction, the sector increasing output again by 20%+ on the month to take overall output in August back to last December’s level. However, successive declines in utility output and a drop in August’s water services output dampened the impact on the month. Services fell short of expectations, rising by just 0.3% (consensus 0.6%), with July’s estimate revised lower to -0.1% (from unchanged). The softness reflected a fall in education and health services output on the month, although there were solid gains across most other sub-sectors and a continued impressive rebound in accommodation and food sector (+10% m/m). Construction output fell by a further 0.2% in August, although July’s 1.6% drop was revised to -1.0%.

The Bank of England (BoE) will take account of this latest data as it considers the outlook for monetary policy in the November Monetary Policy Report meeting. On the face of it the marked slowdown in economic activity into Q3 should serve as a warning against too swift a tightening in monetary policy, particularly as GDP looks set to face ongoing headwinds from higher utility prices, cuts in Universal Credit and eventually increases in National Insurance all pressuring household incomes over what threatens to be a difficult winter. However, from a medium-term inflationary perspective the BoE has to consider this against the additional supply constraints the UK economy faces both in the wake of the pandemic and from Brexit. The latest labour market report saw a clear rebound in jobs – payrolls back to their pre-Covid levels and signs of continued upward pressure in wages. However, signals for the labour market were not clean, with employment being driven largely by a rise in part-time work and large vacancies coming alongside a still large number of people recorded on furlough immediately before its conclusion in September.

With the recent gas price surge now looking likely to drive CPI (Consumer Price Index) inflation to peak around 5% in April next year, before retreating, the Monetary Policy Committee (MPC) is increasingly concerned about the impact of the current transitory inflation spike on inflation expectations as well as the more medium-term balance of supply and demand conditions over the medium-term, policy relevant time horizon. Recent comments from Governor Bailey warning on the impact of inflation expectations have convinced us that the BoE is preparing for a pre-emptive tightening in policy. We change our forecast to envisage the first hike (0.15% to 0.25%) by the BoE in February next year. We then consider a second in August (to 0.50%) and a third in May 2023 (to 0.75%). However, short-term interest rate markets consider a faster pace, including a first hike in December this year and almost fully pricing in a rise to 1.00% by end-2022. A rise in December would follow the first labour report recording post furlough activity. This is plausible, but we suggest the BoE will use December’s meeting to confirm a February hike. However, we believe that current market pricing is too extreme. Combined with an unwind in the BoE’s balance sheet, passively after 0.50% Bank Rate is reached and actively after 1.00% we think that this tightening in financial conditions (as evidenced by marked underperformance in UK yields), will prove too much for the economy and will send inflation below target in 2023.

Market reaction was limited after today’s release, with an initial dip in sterling to both the euro and the dollar unwound.