Still, underlying growth momentum remains weak, and while consumer spending held up in Q1, it’s unlikely to improve in the near term. Meanwhile, the market is now pricing in peak interest rates of 6-6.25%, up from 5.25-5.50% just a month ago. With the hit from higher rates still slowly filtering through the economy, their full effect remains to be seen. 

The economy grew by 0.2% in April, but this was not enough to offset March’s 0.3% contraction. The services sector grew by 0.3% over the month, making it the main contributor to growth. But production output fell by 0.3%, while the construction sector contracted by 0.6%. The best news was that the output of consumer-facing services increased by 1.0% after falling by 0.8% in March.

The economy expanded by 0.1% in Q1 thanks to savings built up during the pandemic. Households reduced their saving rate from 9.3% in Q4 2022 to 8.7% in Q1 2023 to support their expenditure, which was unchanged from Q4. Business investments, meanwhile, were up 3.0% over the quarter.

Looking ahead, growth in Q2 is likely to be similar to Q1, despite improvements in business surveys – we need to remember that the purchasing managers’ index (PMI) excludes the struggling construction and public sectors.

Indicators of consumer spending are mixed. Retail sales volumes increased by 0.3% in May, supported by an additional bank holiday and warmer-than-usual weather. But CHAPS card spending fell by 0.5% in June.

Indicators of consumer confidence have continued to improve, albeit gradually. All things being equal, this bodes well for future household spending – but all things aren’t equal; we need to factor in the drag from higher mortgage payments and people’s desire pay off debts and rebuild the savings they’ve dipped into in recent months.

Companies are also repaying debts as over 80% of the loans they’ve taken out are at floating rates. Meanwhile, shrinking profit margins are putting pressure on turnover expectations and cash reserves.

Overall, the growth picture is finely balanced. Consensus expectations are for the UK economy to have been flat over the first half of this year, with meagre growth to follow in H2.

UK business activity continuing to recover, driven by services: UK PMI

The UK’s headline inflation rate remained stable at 8.7% year-on-year in May, once again exceeding both the consensus expectation of 8.4% and the Bank of England’s forecast of 8.3%. Higher prices for cultural goods, services, recreation, hospitality, and air fares were the main culprits – for example, airline fares were up 20% in May, compared with 2.8% for the same month last year. Meanwhile, goods inflation eased from 10.0% in April to 9.7%, while food inflation dropped from 19.0% to 18.3%.

The key point here is that persistent core inflation is overtaking the drop in energy prices. Core inflation (excluding food and energy) rose from 6.8% in April to 7.1% in May, its highest rate since March 1992. This was led by a sharp rise in services inflation, indicating persistence in domestic inflationary pressures. This is of special interest to the Bank of England, which is worried about second-round effects linked to rapidly rising wage pressures. We may now be in the early stages of a wage-price spiral.

Nonetheless, headline inflation could fall sharply over the coming months. Ofgem will reduce its energy price cap by 17% in July and wholesale prices suggest that energy will make a negative contribution to the headline rate soon. Food inflation should also fall over the coming months. Producer input price inflation eased sharply in May, down from 4.2% in April to 0.5%.

But services inflation will probably take longer to fall, with the latest PMI data suggesting that prices in the services sector are still high, even though they are easing slowly.

Overall, sticky core inflation remains the biggest challenge for policymakers.

Energy and food prices falling but core inflation proving persistent: inflation (% year-on-year)

Both the unemployment rate and redundancies remain low. The unemployment rate inched down by 0.1 percentage point to 3.8% in the three months to April, while redundancies only crept up from 2.8 per 1,000 in March to 3.3 – still a historically low level.

Meanwhile, wage growth accelerated again in the three months to April, with growth in regular pay (excluding bonuses) up from 6.8% in March to 7.2%. This will put further pressure on the Bank of England to raise the rates as it strengthens the argument that inflationary pressures are not yet under control.

However, the market isn’t nearly as hot as headline employment suggests. Labour demand is essentially flat, with vacancies down for the 13th month in a row in May. And as we’ve explained previously, while total employment might still be rising, that’s mainly due to increased numbers of self-employed and part-time workers.  That’s because firms are focusing on cutting costs amid rising borrowing costs. Overall, slack is developing slowly.

Meanwhile, labour supply is picking up. Cost-of-living pressures have been pushing down inactivity since the start of the year, notably among students and early retirees. In the three months to April, the UK’s economic inactivity rate was 21.0%, 0.4 percentage points lower than the previous three months. And immigration is picking up swiftly. According to the UK KPMG-REC Jobs report, total staff availability increased at its quickest rate since December 2020 in May. That said, there are still shortages in some areas – especially chefs, hospitality, cleaners, and drivers.

Overall, the labour market has been resilient so far. We expect that to change gradually as 2023 progresses, but it’s likely to remain an area of relative strength.

Wage growth continues to be higher than expected: regular pay growth (% year-on-year, quarter-on-quarter)

The Bank of England delivered a surprise 50 basis point hike to 5% at its June meeting, its 13th consecutive hike and bringing rates back to mid-2008 levels. The market reaction was fairly muted, still expecting a peak of 6-6.25% by year-end. Further hikes look likely due to the stickiness in both UK consumer price inflation and private sector wage growth.

But could there be fewer rate hikes than the market expects? It’s possible, as slack in the labour market is likely to increase and inflation and wage increases will slow down over the coming months. In short, there’s still considerable uncertainty about the path of interest rates as a range of opposing factors are at play. But over half the tightening that’s occurred to date is still to hit the economy, so the Bank of England needs to tread carefully.

Financial markets expect peak interest rates of 6.0%, up from under 5% just over six weeks ago: market pricing for Bank Rate at future Bank of England meetings

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