GBP And The UK Recession

The UK’s going through a transformative period. The combination of the pandemic and Brexit makes it especially hard to interpret the economic data and extrapolate it into the future. Throw in the political changes and it’s a real mess.

For most of 2022 the pound has suffered against the dollar. Steep losses in GBPUSD have frequently been followed by sharp rallies before the downtrend continued:

The Bank of England couldn’t have painted a bleaker picture at the recent monetary policy meeting (even as they hiked rates by 0.5%). Here’s what they had to say about energy:

Inflationary pressures in the United Kingdom and the rest of Europe have intensified significantly since the May Monetary Policy Report and the MPC’s previous meeting. That largely reflects a near doubling in wholesale gas prices since May, owing to Russia’s restriction of gas supplies to Europe and the risk of further curbs.

Energy bills have already rocketed and the changes to the Ofgem price cap measures in October are expected to see bills increase further. This graphic via Cornwall Insights tells the story:

Wholesale energy prices would be responsible for the bulk of any price rise. According to their modelling, the typical household would pay:

• £3,582 p/a from Oct
• £4,266 p/a from Jan

As the Bank of England point out, this will push inflation even higher, and weigh further on households and their ability to spend:

As this feeds through to retail energy prices, it will exacerbate the fall in real incomes for UK households and further increase UK CPI inflation in the near term. CPI inflation is expected to rise more than forecast in the May Report, from 9.4% in June to just over 13% in 2022 Q4, and to remain at very elevated levels throughout much of 2023, before falling to the 2% target two years ahead.

“Real incomes” is often a confusing term. Simply, this means income after inflation has taken its tax on purchasing power.

Someone earning £100,000 in a year of 10% inflation would need to see a 10% increase in their income the following year to maintain the same level of purchasing power/ spending. So, this isn’t great news for consumers. These projected increases in energy prices are almost certain to reduce their disposable incomes.

How about the central bank's view of the economy as a whole?

GDP growth in the United Kingdom is slowing. The latest rise in gas prices has led to another significant deterioration in the outlook for activity in the United Kingdom and the rest of Europe. The United Kingdom is now projected to enter recession from the fourth quarter of this year. Real household post-tax income is projected to fall sharply in 2022 and 2023, while consumption growth turns negative.

Always look on the bright side, eh? Another chart that tells a story via BNP Paribas here:

Three growth paths. The red line shows the trend before the great financial crisis of 2008. The green line is the pre-pandemic trend. The blue line is the actual GDP plus the Bank of England forecasts.

Stagflation Central?

For now at least, the employment situation has remained strong. Low unemployment, and robust wage growth is helping to weather the storm, even as inflation takes a toll. July’s ONS data confirmed that real (inflation-adjusted) pay was negative 0.9%:

Annual growth in nominal total pay was 6.2%, nominal regular pay was 4.3%, real total pay was negative 0.9% and real regular pay was negative 2.8% in March to May 2022:

ONS

However, if the Bank of England’s recession forecast proves correct, this could all change. If companies decide to cut costs by letting staff go, the stagflation trinity of rising unemployment, high inflation and slow (or negative) economic growth would be complete.

It's noteworthy that the central bank has chosen to paint such a bleak picture. Leaving aside their ability to predict the future with any kind of accuracy, is this more a case of expectation management than realism?

Political pantomime enters the final act…

Liz Truss and Rishi Sunak have both given their own performances of the Enrique Iglesias classic, telling conservative party members (and the rest of the country) “I can be your hero, baby”.

September 5th is a crucial date. The new conservative party leader and Prime Minister will be announced. The most pressing matter will be the economy, especially supporting lower income households struggling with the increasing energy bills.

Crucially, the Bank of England’s forecasts presume no fiscal support whatsoever from the government. If the new Prime Minister plans to stick around, it’s almost unthinkable that they won’t do something to help deal with the energy crisis and tame the inflation/recession winter storm.

It’s a stark contrast to the global financial crisis when rates were cut by central banks and austerity was imposed by governments, especially in Europe.

Truss is by far the favourite according to betting sites such as smarkets, and she plans to put the economy back on track by cutting taxes by approximately £30bn. In part this would be by reversing Sunak’s plan to increase corporation tax from 19% to 25%, and by cutting green levies on energy bills.

Responding to the central banks forecasts she said:

“What the Bank of England has said today is, of course, extremely worrying. But it is not inevitable. We can change the outcome, and we can make it more likely that the economy grows”. “you simply cannot tax your way to growth”.

Sunak believes that the nation must balance the books.

“It’s not the tax burden that is causing the recession. That’s simply wrong. What’s causing the recession is inflation.”

“It all starts with not making the situation worse, because if we just put fuel on the fire of this inflation spiral, all of us, all of you, are just going to end up with higher mortgage rates, savings and pensions that are eaten away, and misery for millions”.

Actions will speak louder than words once the leadership contest ends. It’s clear that the path for the economy, and the fate of the pound are set to be heavily influenced by British politics once again. Can the new PM pull off a great escape for the UK economy?