A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK. To subscribe and/or view previous editions just google ‘Deloitte Monday Briefing’.
The UK’s energy support package announced earlier this month is a huge response to the cost-of-living crisis, costing roughly twice as the COVID furlough scheme. Supporters see it as bold and necessary. Critics condemn it as untargeted and risky for Britain’s finances. What they agree on is that, in terms of cost and reach, this is a shock and awe policy move.
The package caps annual household energy bills at £2,500 over the next two years. This is on top of the £400 energy bill discount announced earlier in the year. Energy prices for businesses will see an ‘equivalent cap’ for six months with the government identifying and supporting businesses deemed vulnerable beyond six months. Energy companies are being provided with up to £40bn in support to reduce the risks of a liquidity crunch in the event of a sharp rise in wholesale gas prices.
The government’s plan will mean average annual energy bills rise from the current £1,971 to £2,500 eventually, instead of peaking at over £6,000 next year. Much lower energy prices mean lower inflation. We expect inflation to peak at 11% this winter, well below our previous forecast peak of 16% next spring. Nonetheless, underlying inflationary pressures remain strong. Core inflation, which strips out the effect of energy and food prices, is running at above 6%, the highest level in 30 years. It will take time for slower growth to dampen inflationary pressures. We expect price pressures to remain elevated through next year, with inflation falling to 4.6% by the end of 2023 and 2.2% by the end of 2024.
The energy package will shield households from the worst effects of high energy prices, but still leaves them facing a squeeze on spending power. We continue to expect the UK economy to experience a recession, albeit a shorter and shallower one than had the government not stepped in with support. We think the recession will begin in the fourth quarter of this year, with activity falling by a total of 1.6% over three quarters, and growth resuming in the second half of next year. This is a much smaller contraction than those seen during the pandemic (21.5%) and the financial crisis (5.9%), and is slightly less than that seen in 1990–92 (2.0%), but it is likely to cause significant disruption.
As growth contracts corporate insolvencies and unemployment are likely to increase. The labour market is running hot but shows early signs of a slight cooling. Job vacancies have dropped from record levels and firms’ hiring intentions have softened. As higher costs and weaker demand squeeze corporate margins, we expect the unemployment rate, which is currently at 3.6%, a 48-year low, to rise, peaking at 5.0% in the first quarter of 2024. This is roughly similar to the peak seen during the pandemic.
Although real wages are likely to decline through most of next year, savings accumulated during the pandemic and the energy price cap will offer some support to consumer spending. Overall, we expect household consumption to contract by 0.9% over the period of the recession. This is much smaller than the declines seen in the pandemic and the financial crisis but similar in scale to that seen in the early-90s recession.
As well as helping consumers, the energy package will result in a lower peak in inflation and deliver a shallower downturn. This is all too good to be true and, indeed, it is. There are no magic bullets in economic policy.
Injecting the equivalent of perhaps 5.0% of borrowed money into the economy sharpens the dilemma facing the Bank of England as it seeks to dampen demand and bring down inflation. The fact that energy subsidies will bring down inflation, and that the economy is slowing, has not changed the view in financial markets that interest rates are heading sharply higher. Financial markets see the Bank raising UK rates from a current 1.75% to at least 2.25% this Thursday, with rates ending this year at 3.5% and peaking at around 4.5% next summer. If the markets are right, we are heading for the sharpest, fastest tightening of monetary policy in more than 30 years.
Government spending on such a scale, funded by public borrowing, runs other risks too. If the package costs the exchequer about £150bn it will raise the level of public debt from about 96% of GDP to 104%, the highest level since the 1950s. If energy prices remain high for more than two years the cost of the scheme would escalate still further. A weak pound, high inflation and rising public borrowing could yet test the patience of investors and push UK government borrowing costs higher.
Cutting energy bills is popular and, in many ways, essential. Only time will tell whether doing so on the scale and the manner chosen by the government is the right course of action.
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Please join me for our annual ‘Back to School’ webinar on the global economic outlook today, 20 September, at 12:00 BST. Register here.
Our new ‘Navigating Stagflation’ webinar series also begins at 13:00 BST on Thursday, 22 September. This series will assess the changing economic environment during this period of high inflation, and the corporate response to it. For a detailed schedule and to register for the inaugural edition, featuring Bill Marquard, partner and corporate strategy expert from Deloitte’s Chicago office, click here.
