UK Outlook Brighter as Recession and Cost of Living Fears Recede

The gloom cloaking the UK economy is starting to lift, giving another potential boost to Prime Minister Rishi Sunak.

(Bloomberg) — The gloom cloaking the UK economy is starting to lift, giving another potential boost to Prime Minister Rishi Sunak.

Just four months ago, the Bank of England warned that Britain was facing its longest recession in a century and a collapse in living standards. 

Neither is the case any longer. The BOE this week effectively canceled the recession and said the period of falling household incomes is over. That points to a stronger backdrop for Sunak and the Conservatives in the year or so leading up to the next election.

“The prospects for the economy in terms of growth are now considerably better, and I think it is reasonable to say there is a pretty strong likelihood that we will avoid a recession this year,” BOE Governor Andrew Bailey told the BBC on Friday.

Sunak must call an election by early 2025 and has been trailing the opposition Labour Party in polls since he took office in October. That gap has narrowed as Sunak’s government stopped the turmoil that brought down his predecessor, Liz Truss.

Stronger growth and lower inflation would help Sunak, who made helping people weather the cost-of-living crisis one of his key priorities. Britain alone in the Group of Seven has yet to regain its pre-pandemic level of output, and wages are falling further behind inflation. It also would help the Treasury’s finances.

Most measures of UK economic prospects are improving. Alongside its quarter-point hike in interest rates to 4.25% on Thursday, the BOE upgraded its growth forecast for the three months to June to show gross domestic product increasing “slightly” instead of contracting 0.4%.

Employment is forecast to grow 0.2% in the second quarter, not drop 0.4% as predicted in February. Real household disposable incomes could “remain broadly flat in the near term, rather than falling significantly,” the minutes to this week’s Monetary Policy Committee rate meeting said.

Those figures suggest that households will soon feel better off, despite the current 10.4% level of inflation. 

  • In April, the legal minimum wage rises 9.7% to £10.42 ($12.74) an hour, and benefits rise 10.1%.
  • That same month, inflation will drop into single digits and “fall sharply over the rest of the year” as falling energy prices and more favorable comparisons with a year ago feed through, the BOE said.
  • Annual energy costs for the typical household will remain capped at £2,500 in April and are on course to fall to about £1,800 in July.
  • Households will also feel richer simply because they spend less on energy in spring and summer as they don’t heat their homes.

Past growth has also proved stronger than projected. In November, output was forecast to shrink 0.3% in the final quarter of 2022. Instead, it flatlined. Private-sector activity, as measured by the purchasing managers’ index, is positive, with order books growing and confidence at its highest level since the invasion of Ukraine 13 months ago.

The closely watched survey added to “signs that a near-term recession has been avoided,” Chris Williamson, chief business economist at S&P Global Market Intelligence, said Friday. 

Consumer confidence is improving, and retail sales recovered in February to pre-Covid levels despite an 18% increase in food and non-alcoholic drinks prices over the past year.

The economy’s resilience has taken forecasters by surprise, given the record terms of trade shock caused by energy prices and the fastest monetary tightening since the late 1980s, as the BOE raised rates from 0.1% to 4.25% in 16 months. 

The last equivalent terms of trade shock in the 1970s did cause a recession, as did the rate rises of late 1980s.

Kallum Pickering, UK economist at Berenberg Bank, said the difference this time has been the UK’s reduced reliance on natural gas and the strength of both household and corporate balance sheets, thanks to savings amassed during Covid. Those savings have insulated the economy against rate hikes. 

The energy-price shock has been less severe than expected because the UK has managed to operate with 15% less gas than previous years, according to Pickering’s calculations using data presented by the Office for Budget Responsibility at this month’s budget.

The fiscal loosening in the budget is expected to add 0.3% to GDP and reduce headline inflation, the BOE said. Now that a deal over the Northern Ireland Protocol has been agreed with the European Union and the prospect of a Scottish referendum receding, the investment climate has also improved.

“For the first time in seven years we have no populists in the UK,” Pickering said. In place of his forecast last autumn for a recession in which the economy shrank 2.5%, he now expects “stagflation with a strong labor market rather than recession.”

The stronger economic outlook makes at least one further rate rise to 4.5% likely, Andrew Goodwin, UK economist at Oxford Economics, said. Markets are priced for a 4.5% terminal rate.

There are risks to the outlook, mainly from the ongoing turbulence in the banking sector and financial markets — with Deutsche Bank the latest institution facing difficulties. Further setbacks could drive up bank funding costs that “result in a tightening in financial conditions” and damage growth prospects, Pickering said.

The BOE has stressed that UK banks are “safe and sound” and will provide a timely update next on Tuesday, when Bailey and Prudential Regulation Authority Chief Executive Sam Woods testify to Parliament about the rescue of Silicon Valley Bank’s UK operation. It was sold to HSBC for £1 earlier this month after a deposit run that saw £2.9 billion withdrawn by customers in a day.

Catherine Mann, a BOE policy maker, said the banking and financial market turbulence could influence the BOE’s forthcoming interest rate decisions, a hint that even she might soon be ready to pause the quickest monetary tightening in three decades. 

If higher perceived credit risk lead to tighter financial conditions, that will be “on the plate” in the May decision as it “would have the same effect as a bank rate rise.”

“We will be getting data in real time about the financial conditions, credit conditions, and if they are tightened … we will take that into account,” Mann said.

–With assistance from Tom Rees and Lucy White.

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