Economic update: Growth slows as inflation rises

Economic data and reports in June have focused on the rising cost of living and gloomier economic outlook. With inflation above 9%, the Bank of England has continued to raise interest rates. GDP growth forecasts have been lowered, as household finances are squeezed by higher prices.

This Insight summarises economic developments in June and looks at prospects for inflation and economic growth in the months ahead.

Inflation rises to 40-year high…

Inflation hit a 40-year high in May 2022, with consumer prices up 9.1% compared to a year before. One cause is the rapid increase in the cost of energy, with household bills rising sharply and petrol prices reaching record highs (to over 190p per litre on 27 June). The conflict in Ukraine has exacerbated pre-existing issues, driving global energy prices up.

Another major factor behind rising inflation is the price of goods, which were 12.4% higher in May than a year before. This is the most since the existing inflation dataset begins in 1989. Strong demand from consumers for goods and higher costs for businesses – partly reflecting supply chain bottlenecks – are being reflected in higher prices. This is largely a global phenomenon resulting from the pandemic.

In addition, the pace at which food prices have risen has picked up recently. In May they were 8.6% higher than a year previously, the highest annual rate of increase since April 2009. They seem likely to rise further, with the Russian invasion of Ukraine resulting in higher prices on global food markets. One estimate from the Institute of Grocery Distribution suggests grocery price inflation in the UK could hit 15% this summer.

…and expected to rise further

Many economists are forecasting inflation to peak later in 2022, with expectations that the highest rate will be in October. This is when the household energy price cap in Great Britain, set by the regulator Ofgem, will next change. Many, including the Bank of England, now anticipate a further increase in the price cap of around 40%.

The Bank of England said it expects inflation to rise to slightly above 11% in October, up from its previous estimate of around 10%. The price outlook remains uncertain and, in the short term, beholden to global events, notably in international energy and food markets.

Interest rates increased again

Responding to high and rising inflation, the Bank of England’s Monetary Policy Committee (MPC) raised interest rates for the fifth meeting in succession on 16 June. Rates were increased by 0.25 percentage points to 1.25%, up from an historic low of 0.1% in December 2021.

Higher interest rates increase the cost of borrowing for companies and individuals, typically reducing demand in the economy. In turn, this reduces pressure on companies to raise prices, keeping inflation down.

The challenge facing the Bank of England

The MPC’s target for inflation is 2% and by raising interest rates it hopes to lower the risk that inflation remains persistently above 2%. The MPC says that four-fifths of the overshoot above the 2% target is due to energy and goods, something it says is largely determined by global factors.

The difficulty for the MPC is that while inflation is high, supporting the need for higher interest rates, the economic growth outlook is weak. Normally, slowing growth would result in reduced inflationary pressures (prices going up at a slower rate) and lessen the need to raise interest rates.

However, the current combination of rising inflation and weakening growth presents the MPC with a difficult balancing act. If it doesn’t raise interest rates, inflation could remain persistently above target. If the Bank raises rates too much or too quickly, it could make the downturn in economic growth worse and exacerbate the costs that come with it (such as higher unemployment).

Economic growth outlook deteriorating

The rising cost of living is squeezing household budgets. For example, 60% of adults reported spending less on non-essentials in June, with three-quarters saying they were worried about increases in the cost of living. A prominent measure of consumer confidence in June fell to its lowest level recorded since the survey began in 1974.

It is expected that this will result in consumer spending growth slowing over the course of the year, reducing GDP growth. Retail sales, accounting for around one-third of total consumer spending, fell by 0.5% during May.

Expectations for GDP growth have been lowered in recent months. In early June, the Organisation for Economic Co-operation and Development (OECD) lowered its forecasts. It now expects the UK economy to grow by a total of only 0.1% from the first quarter of 2022 until the last quarter of 2023. In its previous forecast made in December, the OECD expected cumulative growth of 3.8% over the same period.

Some positive developments

Despite the generally gloomy nature of economic news of late, there are some indicators that may be more supportive of growth. These include:

• The Government’s cost of living support package, announced by the Chancellor on 26 May. This includes a £400 discount to energy bills for all households in October and a £650 payment to over 8 million households, largely on lower incomes. Initial estimates from the Bank of England suggest the package will boost GDP by 0.3% and inflation by 0.1 percentage points.
• Unemployment remains low at 3.8%, with large numbers of job vacancies, which should support overall household income levels across the economy (compared to a situation with higher unemployment).
• Households accumulated a large amount of above normal savings during the lockdowns, when spending opportunities were limited but incomes remained steady. The ONS estimates this amounts to over £140 billion; others put the figure even higher. This extra pool of savings could be used to support household finances as inflation reduces purchasing power.

About the author: Daniel Harari is a researcher at the House of Commons Library, specialising in UK and international economies.

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