Parliament returns from summer recess on 5 September to a range of severe economic challenges. High inflation, the threat of a recession and falling household incomes are among the issues the new Prime Minister will face on taking office.

This Insight summarises economic developments in August and considers the outlook for the months ahead.

Cost of living crisis

The cost of living crisis shows no sign of easing with inflation reaching 10.1% in July. This is its highest level for 40 years.

Over the 12 months to July, the cost of electricity, gas and other fuels increased by 70.3% and food by 12.8%. Some food prices have risen particularly rapidly with the cost of milk, cheese and eggs going up by nearly 20%.

The Institute for Fiscal Studies has pointed out that poorer households are likely to face higher rates of inflation than the headline figures suggest. This is because they spend a higher proportion of their income on food and energy and these prices are rising particularly fast.

Inflation is forecast to keep rising with further energy price increases anticipated. The Bank of England has forecast that inflation will reach just over 13% in the last three months of 2022. Inflation could rise to more than 22% next year if gas prices remain high, according to Goldman Sachs.

The high level of inflation has led to real wages (wages adjusted to take account of inflation) falling in recent months. Real wages were 2.5% lower in the second quarter of 2022 compared with a year earlier. Excluding bonuses, real wages fell by 3.0%, a record fall.

This chart shows that inflation has risen from 0.4% in February 2021 to 10.1% in July 2022. Between 2016 and 2021, inflation was much lower, reaching a peak of around 3% in 2017.

Interest rates up

The current arrangements for controlling inflation were put in place in 1997, when the Bank of England gained independence from the Government for monetary policy. The Government sets an inflation target, currently 2.0%, for the Bank. The Bank’s Monetary Policy Committee sets interest rates to meet this target.

Inflation has been low and stable for most of the period since the Bank was made independent. Between May 1997 and April 2021, inflation averaged 1.9% and varied between -0.1% and 5.2%. The current rate of inflation (10.1% in July) is by far the highest since the Bank gained independence and is an unprecedented challenge for the Monetary Policy Committee.

To bring inflation back to its target, the Bank of England increased interest rates by 0.5 percentage points in early August to 1.75%. This is the largest increase since 1995. Interest rates are now at their highest level since early 2009, although still low by historical standards. The Bank has increased interest rates several times in recent months.

UK interest rates have been raised by the Bank of England since December 2021, from 0.1% to 1.75% in August 2022.

Economic slowdown

GDP fell by 0.1% in the second quarter of 2022, the first fall in GDP since early 2021. Service sector output fell by 0.4%, manufacturing output was unchanged while the construction sector grew by 2.3%.

real GDP fell by 0.1% in the second quarter of 2022, the first fall since the first quarter of 2021.

The rise in gas prices has led to a worsening outlook for the UK economy. The Bank of England forecasts that the economy will go into recession later this year (a recession is generally defined as two or more consecutive quarters of falling economic output). The Bank forecasts that output will fall from the last quarter of 2022 to the last quarter of 2023. Even when growth resumes, it is forecast to be “very weak”.

The deteriorating prospects for the economy can be seen from the fact that independent forecasters now expect GDP growth of only 0.5% in 2023. At the March Budget, the Office for Budget Responsibility forecast growth of 1.8% in 2023.

Further reading

About the author: Dominic Webb is a researcher at the House of Commons Library, specialising in economic policy and statistics.

Photo by KWON JUNHO on Unsplash

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