Outlook for the UK economy in 2023: a getting-better sort of year

Nobody can be under any illusions: 2023 is going to be a tough year. But, providing that the war in Ukraine doesn’t escalate further, it should at least be a getting-better sort of a year (in contrast to 2022, which went downhill rapidly after a bright start). In common with much of the rest of the world, the UK spent 2021 learning to live with Covid, and 2022 trying to deal with the after-shocks from the war in Ukraine. The UK therefore finds itself in much the same boat as everybody else, struggling to cope with the resurgence of inflation and trying to cushion the adverse impact on households and businesses of sky-high gas and electricity prices.

Yet it should also be recognised that important progress has been made since the outbreak of the Ukraine war in February. The initial surge in global commodity prices has been largely unwound; the Brent crude price is back at about $80 a barrel; gas prices remain very high, and are likely to remain so, but have fallen sharply since the extraordinary levels reached last August; the rate of inflation has very likely passed its peak; and the Bank of England is set to raise Bank Rate just one more time. The UK has also been able to effect a speedy recovery from market instability during September and October, such that the premium that was then demanded by the markets for holding sterling assets has disappeared.

The recession, which started in the third quarter of 2022, is likely to be fairly short and very mild, by comparison with previous ones. GDP in real terms (that’s to say after taking account of inflation) is forecast by HSBC to contract by not much more than 1%, as against the falls of around 6% suffered in the early 1980s and again in 2008-09. But while the economy should start to grow again later in 2023, it’s going to be well into 2024 before it’s the same size as it was before Covid struck. Taking 2023 as a whole, real GDP is expected to contract by 0.6% compared with last year, with a sluggish revival of 1.5% penciled in for 2024.

The reason that the economy finds itself in a recession is primarily the sharp squeeze on the spending power of households, brought about by very high gas and electricity prices and more generally by the fact that inflation has been running well ahead of the increase in earnings. Although inflation is now set to ease, having peaked at 11.1% last October, getting it back to the government’s target of 2% is likely to take at least three years. But, once inflation is back roughly in line with earnings growth, then the squeeze on living standards will abate, allowing the economy as a whole to start expanding again.

With many people forced to cut back on day-to-day spending, the retail and hospitality sectors will face an especially challenging time, with smaller businesses being particularly hard hit by huge increases in their energy bills. But, with some people still able to draw on savings put away during the pandemic, other activities, such as travel and leisure, may be less affected. House prices started falling towards the end of last year, and this trend is set to continue throughout 2023, with higher borrowing costs more than offsetting the shortage of supply. But, assuming that the peak of the interest rate cycle is close at hand, the drop in prices should be confined to around 5%.

Of course, what happens to the economy isn’t just about consumers (though with spending by households accounting for nearly two-thirds of GDP, when measured in terms of expenditure, it’s hard for the other elements to counteract the effects of falling real household incomes). But, with much of the rest of the world either in recession or close to it, 2023 is likely to be challenging for exporters. Meanwhile, given the uncertainties of the present environment, the ongoing challenge of containing costs, and the imminent end of the “super deduction” investment incentive, many businesses aren’t in the mood for shelling out on capital investment projects.

The weakness of demand, coupled with higher input prices, labour costs, and interest rates, will make 2023 a tough year for many businesses, irrespective of which sectors they operate in. The number of failures has already risen sharply, and will very likely rise further, but should remain below the levels seen back in 2008-09. For one thing, this recession is nothing like as severe. And many firms are, like households, still sitting on reserves of cash built up during the pandemic, added to which businesses in general are carrying less debt than they were 15 years ago. While the economy is contracting, turnover and costs are still rising, thanks to inflation, which means that working capital needs will also keep growing.

Along with soaring energy costs, the biggest issue facing the UK is the ongoing shortage of people to fill available jobs. Conditions in the labour market have finally started to ease, although the number of vacancies, at close to 1.2 million, is still far in excess of what would have passed for normal before the pandemic. Recent falls in global food and energy prices, along with government support for utility bills, will mean that food and energy will become less important drivers of inflation. What happens to other prices, as reflected in “core” or underlying inflation, will dictate the subsequent trajectory of the headline inflation rate. There’s little evidence, so far, that “core” inflation is easing, with the annual rate in November still at over 6%.

What happens from here will depend largely on how quickly the logjams in the labour market are cleared – a process that is likely to take some time. For this reason, the “core” inflation rate is forecast by HSBC to still be at around 4% by the end of 2023, with the headline rate at just over 5%. That suggests that the present gap between pay growth and inflation won’t close until the autumn.

The speed at which the inflationary surge abates will then determine what the Bank of England (BoE) does with interest rates. In common with other major central banks, the BoE faces a tough call about how high to lift rates and how long to keep them there. The forecasts contained in November’s Monetary Policy Report suggest that they don’t anticipate raising rates much further, and on this basis HSBC is expecting just one more interest rate hike, of just 25 basis points, at the policy meeting in early February. That will mean Bank Rate peaking at 3.75%, a good deal lower than seemed likely during the upheavals in September and October. This would also be good news for those people who will need to refinance their mortgages in the next year or so, with rates for two- and five-year fixes likely to top out at under 5%.

But what if a Bank Rate of 3.75% turns out not to be sufficient to tame inflation? What if it’s still running at 7-8% by the autumn? In that situation, the Bank of England would have little choice but to take a second bite of the rate-hiking cherry. The obvious risk is that further increases would then snuff out any nascent revival, possibly pushing the economy back into recession.

Even if that scenario can be avoided, it’s not expected that the BoE will be in a position to start cutting rates before the end of 2024. Having had to deal with the most serious bout of domestically-generated inflation since the Bank of England was put in charge of monetary policy in 1997, they won’t want to risk their credibility any further by lowering Bank Rate too early.

As for sterling, after a roller-coaster few months, it’s now on a firmer footing. Downside risks remain, including any renewed political instability or a deterioration in relations with the EU over the Northern Ireland Protocol. But, in the absence of those eventualities, the pound is expected to appreciate modestly against the dollar during 2023 on the back of an end to the aggressive interest rate hikes that the US Federal Reserve has been delivering since the spring of last year; sterling is forecast to end the year at $1.25, while remaining steady against the euro at around €1.14.