Economic update: Short recession looming and concern over US climate policies

The UK economy was stagnant at the end of 2022, with a short recession expected in 2023. Consumer confidence and business output are falling, but businesses have been more optimistic in January than in the previous eight months, partly due to easing cost pressures and falling energy prices.

The Bank of England is expected to raise interest rates again in early February, potentially because of inflationary pressures, growing nominal wages and more resilience in the economy than forecast. Wages continue to grow slower than inflation.

There are also concerns that recent US climate policies could affect green investment in the UK.

Falling consumer confidence and business output

Consumers’ confidence in their finances and the economic situation in general has been falling since mid-2021, with a slight improvement at the end of 2022. The volume of retail sales in the three months to December 2022, fell by 5.7% compared to the same period last year.

Retailers suggest consumers are cutting back on spending because of increased prices and affordability concerns.

UK private sector business activity continues to slow. Office for National Statistics data shows manufacturing output was 1.2% lower during September and November 2022, compared with the previous three months. Output decreased by 6.2%, compared with the same period the previous year.

Service industries’ output, including retail, finance, and leisure, dropped 0.1% over the three months to November, but was 1.4% higher than during the same period in 2021.

However, regardless of falling business output, January flash estimates show manufacturers and businesses are slightly more optimistic about their performance for the year ahead. Firms appear to hope economic conditions will improve globally and inflationary cost pressures will fall.

Labour market remains strong, but somewhat slowing

In the labour market, trends seen in recent quarters have continued. Earnings in real terms and the number of vacancies are falling, while redundancies increased by 30,000 from the last quarter, reaching 97,000.

There are signs unemployment is rising, though the unemployment rate was still low between September and November 2022, at 3.7%.

Nominal wages rose fast, by 6.4%, (including and excluding bonuses) in the three months to November 2022. However, average wages fell in real terms (adjusted for inflation) by 3.8% on an annual basis.

Employment increased both in the last quarter and over the last year but is still 203,000 below its pre-pandemic level. There are nearly half a million (498,000) fewer people in the labour market since the beginning of the Covid-19 pandemic.

Inflation slowing, but interest rates expected to go up

The Governor of the Bank of England, Andrew Bailey, said, in a 19 January interview with the Western Mail’s BusinessLive website, that recent falls in wholesale energy prices and other related developments had triggered more optimism about easing inflation.

Andrew Bailey said the dip in inflation from 11.1% in October to 10.5% in December was “a sign that a corner has been turned.” According to the Office of National Statistics, inflation was slowing mainly due to lower prices of fuel, clothing and footwear, and recreation and culture.

The Bank of England raised interest rates to 3.5% in December. Financial analysts expect the Bank’s Monetary Policy Committee to raise the rates by a further 0.5% in early February. This would be owing to fears of underlying high inflation in the medium term. Services sector prices, for example, have increased despite interest rate rises. Strong wage growth and “broad unexpected resilience in the economy” are also expected to drive up inflation, according to the Financial Times.

Risk of recession remains

The UK economy may have narrowly avoided going into a recession (often defined as two consecutive quarters of contracting economy) in the last three months of 2022. This was due to 0.1% growth measured by GDP, recorded in November 2022 compared to October, which makes it more unlikely that the growth in Q4 was negative.

The overall outlook remains sombre for the first half of 2023. A 23 January forecast by EY ITEM Club, an economic forecasting group, is that the expected recession may be deeper than previously thought, with GDP contracting by 0.7% in 2023. This is because of limits on the Energy Price Guarantee, higher taxes on high earners, tighter fiscal policy, and predicted rising interest rates.

Challenges for green investment

Recent US climate-related policies, including the Inflation Reduction Act (IRA), have created debate about their effect on the UK international trade and investment.

The US IRA, passed in August 2022, makes $369 billion available to climate and clean energy programmes. The Act provides tax credits and other incentives to consumers and businesses. For example, people will be able to claim tax credit on electric vehicles. Businesses will be stimulated to invest in renewable energy and clean hydrogen. However, the measures are often contingent upon the goods being made or components sourced in the US. This has worried European countries.

There are concerns that increasingly proactive US and EU green policies might divert green investment from the UK. Speaking at University College London on 23 January, Tony Danker, Director General of the Confederation of British Industry (CBI), called upon the Government to respond by making “smart fiscal choices” to boost investment in innovation and green technologies.

There also are fears the Act may create subsidy competition between countries and trade disputes.

The European Commission has argued the IRA discriminates against EU electric vehicle producers and has asked for a waiver. To counterbalance the US policies, the EU is also contemplating more relaxed rules for state aid to businesses, and funding for Member States to support green industries.

It’s been widely reported that UK ministers have approached the US Government for UK goods to be included in any waivers of the “buy America” principle in the IRA.

Chancellor Jeremy Hunt called for optimism in his Bloomberg speech on 27 January and said the UK green and clean energy sector was one of the world’s most attractive for investment. The Spring Budget expected on 15 March may further clarify the Government’s plans.

About the Author: Ilze Jozepa Researcher at the House of Commons Library, specialising in international trade

Photo by Josh Appel on Unsplash