This year has seen a significant deterioration in the medium term economic outlook. Rising inflationary pressures are causing a cost and wellbeing crisis for households and businesses, destabilising the recovery from the pandemic, giving rise to new economic risks and raising the prospect of a prolonged recession.
We have also had an unprecedented period of economic and financial uncertainty following the UK mini budget, which has significantly increased short term policy and economic uncertainty. This has been most visible in financial markets with increased borrowing costs and the need for the Bank of England to intervene to stabilise financial markets. The economic implications of this have already fed through to the real economy – economic activity, uncertainty, expectations and confidence have all been material impacted. Despite the reversal of many of the unfunded tax policies, the UK economy has already been impacted and has created more uncertainty for addressing the economic challenges ahead.
Inflationary pressures have been building since Covid restrictions were fully removed earlier this year. However, supply in the economy recovered more slowly than demand, adding to inflationary pressures. This was initially expected to be temporary as the economy adjusted, however the war in Ukraine and the subsequent constraints on gas supplies into Europe risks both a more prolonged period of energy price inflation and physical supply constraints.
In the immediate term, the outlook for businesses and households is significantly more challenging than expected at the start of the year. Business surveys for August and September are already indicating that activity is contracting while cost pressures remain elevated as businesses face a significant rise in energy prices, combined with rising staff costs. Overall labour market conditions remain tight, with unemployment at near record lows, however there are indications that recruitment activity has moderated as the outlook for demand has weakened and business adjust activity to deal with increased cost pressures.
Household finances are being squeezed, with the rise in inflation resulting in further falls in median real incomes, which fell for their eighth consecutive month in September, and consumer sentiment falling to its lowest level since November 2020.
The Energy Price Guarantee for households and businesses to tackle the cost crisis is an important intervention. It should reduce inflationary pressures in the short term and reduce the impact on output, but is only temporary. Nonetheless, even with the energy price support in place, the energy price cap from October is double what it was last year and it is not clear what the long term response to prices will be for households and businesses given the review and the changes from April 2023.
Businesses in particular have little certainty around the outlook, while broader inflationary pressures, rising interest rates and a weak exchange rate are still set to place considerable new cost pressures on households and businesses at a time when they are continuing to recover from the pandemic. Therefore, we are likely to see significant changes in business models to deal with adverse supply shocks relating to energy and labour inputs.
This edition of the State of the Economy considers different future economic scenarios for inflation and unemployment while also reflecting on the uncertainty facing energy demand and supply as well as wage levels. It highlights how the impacts of inflation are uneven, with those in stable employment and able to protect their real income, alongside those that accumulated savings during the pandemic, are more resilient to inflationary challenges.
Finally, the current outlook for the economy is particularly complex given the different factors impacting the economy at this time and the market responses to UK Government fiscal policy announcements. All of which suggests a path of uncertainty over the winter period and more turbulence in relation to economic conditions. At best, we can expect a shallow recession but as our scenarios work highlights, risks are increasingly weighed towards a more prolonged disruption to output and economic activity.
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