Economic update: Much for the new Chancellor to consider

With the UK having a new prime minister and monarch in the same week, one could be forgiven for assuming economic news would take a back seat this month. However, the economic effects of Russia’s invasion of Ukraine have not gone away, and the new administration has a lot to deal with.

This Insight looks at the economic news of the past month and considers some of the implications for the Government.

A mini-Budget with major implications

The newly appointed Chancellor, Kwasi Kwarteng, will get a sharp introduction to the job this Friday when he presents his fiscal statement (see the Library’s background briefing for more details). We’re expecting to hear about potential tax cuts, as well as more details of the energy bills package announced on 8 September.

There hasn’t yet been an official estimate of the cost of this package, and the final total will depend on the wholesale price of gas as well as the amount used. However, most informed estimates place it at around £150 billion, an amount that would likely require new legislation and an increase in borrowing.

Because energy prices have been one of the largest contributors to inflation in recent months, capping prices in this way means increases to inflation may be limited, at least in the short term. The Bank of England and a number of other economists now expect inflation to peak in October this year at around 11%. This is below the 13% forecast by the Bank of England in August and far below the 22% that US bank Goldman Sachs thought it could reach if gas prices stayed as high as they were.

High inflation has affected much of the economy, so limiting it in the short term would also result in several improvements. One would be reducing government’s debt interest costs in the short term: central government debt interest payable was £8.2 billion in August 2022, the highest August figure on record in cash terms, of which £4.7 billion was caused by the rise in inflation. Business rates are also linked to inflation; the CEO of the British Retail Consortium has said this could cost retailers an extra £800 million next year without action.

Over the longer term, the energy support package may lead to higher inflation than would otherwise have been the case. As the Bank of England notes, by protecting household budgets it means household spending “was likely to be less weak” than previously anticipated. This could lead to higher interest rates and, in turn, debt interest over the longer term.

The economy has been struggling in recent months. GDP did not grow at all over the three months to July, and retail sales fell across all the main sectors in August. Activity in the manufacturing sector as measured by the Purchasing Managers’ Index also fell in August, for the first time since May 2020. As a result, it is widely expected the UK either is or shortly will be in recession; however, the recession may be less severe than it would otherwise have been with the new energy price measures.

Interest rates likely to rise even further

The Bank of England’s Monetary Policy Committee has raised interest rates at each of its last seven meetings, including a 0.5 percentage point increase announced on 22 September which takes the main rate up to 2.25%. A poll of economists, conducted by Reuters prior to this recent meeting, found interest rates are expected to reach 3% before the end of the year, which would be the highest level since November 2008.

As we noted in our economic update in June, the Bank has a difficult balancing act when it comes to interest rates, as raising them too high could make any recession worse. However, in evidence to the House of Commons Treasury Committee, the Governor of the Bank made it clear he considered the Russian invasion of Ukraine to be the most important factor in the UK’s sluggish economic growth, rather than monetary policy.

Uncertainty in the longer term

Short-term economic factors such as global instability are not the only things affecting the economy. Labour market statistics for September show that although the unemployment rate in May to July 2022 was 0.2 percentage points lower than in the previous quarter, the employment rate had also fallen by the same amount. This is because the number of people leaving the labour market entirely has increased, partly because of people going back into full-time study, but also because of long-term sickness (very likely the effect of long Covid, according to the Institute for Fiscal Studies).

We won’t have any official estimates of the medium-term implications of this week’s economic announcements for some time, as Friday’s fiscal statement will not be accompanied by official forecasts from the Office for Budget Responsibility. However, we may not have too long to wait, with the full Budget still to come in the next few months.

About the author: Philip Brien is a researcher at the House of Commons Library, specialising in spending.

Image: Bank of England / looking up, by George Rex. Creative Commons Attribution 2.0 Generic (CC by 2.0)