Sterling eyes potential rate cuts as labour government tackles subdued growth

Spending spree or belt-tightening? Labour's fiscal dilemma

The UK's fiscal policy has seen notable developments over the past five months. The Spring Budget 2024, presented in March, introduced measures aimed at stimulating the economy, including a further 2 pence reduction in the main rate of employee and self-employed National Insurance contributions. This, coupled with other measures like increases to the High Income Child Benefit Charge thresholds, points to a loosening fiscal stance in the near term. The Bank of England estimates these measures will "increase the level of GDP by over ¼% over coming years". However, the overall stance of fiscal policy is expected to tighten over the projection horizon as the impact of past loosening measures fades. The UK government budget deficit for the 2023-24 financial year was 4.9%, down from 5.5% in the previous year, according to the Office for Budget Responsibility. This tightening, combined with the potential for further fiscal consolidation measures from the newly elected Labour government, could weigh on growth prospects. Fiscal policy plays a crucial role in influencing aggregate demand and, by extension, inflation. It can also impact potential supply, for example through incentives for labour market participation. The new Labour government's fiscal plans will be closely watched by market participants, as they will signal the government's commitment to stimulating growth or reining in public finances. In the short term, the focus will be on assessing the impact of the Spring Budget measures on the economy and any indications of the new government's fiscal intentions.

UK economy: Labour inherits a mixed bag

The UK economy has experienced a mixed performance over the past five months. After contracting in the second half of 2023, GDP rebounded by a stronger-than-expected 0.6% in Q1 2024, driven by a combination of factors including rising real incomes and government spending. Monthly GDP data also point to a continued recovery in early 2024. However, business surveys suggest a more subdued pace of underlying growth, with some sectors, like consumer-facing services, reporting weakness. The newly elected Labour government has inherited an economy facing a number of challenges, including subdued growth, persistent inflation, and a tight labour market. While some indicators, like consumer confidence, have improved, businesses have expressed concerns about potential policy changes under the new government. The next five weeks will be crucial as market participants assess the Labour government's policy agenda and its potential impact on the economy.

Key economic indicators:

GDP Growth Rate: The UK economy grew by 0.7% in Q1 2024, exceeding initial estimates. Monthly GDP data suggest continued growth in early 2024, but business surveys point to a slower pace of underlying growth, "of around ¼% per quarter". The outlook for the next five weeks will depend on the Labour government's policy announcements and their impact on business and consumer confidence. Beyond that, the Bank of England projects a gradual pickup in growth, reaching just over 1½% by the end of the forecast period.

Inflation rate: CPI inflation fell to 2.0% in May 2024, reaching the Bank of England's target. However, inflation is expected to rise slightly in the second half of the year due to base effects from energy prices. Core inflation remains elevated, reflecting persistent domestic price pressures. The outlook for the next five weeks is for inflation to remain close to the 2% target.

Unemployment rate: The unemployment rate stood at 4.4% in the three months to May 2024, its highest level since late 2021. The Bank of England projects a further increase in unemployment, reaching around 4¾% by the end of 2025. The outlook for the next five weeks is for the unemployment rate to remain elevated.

Average weekly earnings growth: Average weekly earnings growth has eased in recent months, falling to 5.7% in the three months to May 2024. However, wage growth remains above pre-pandemic levels, reflecting a still-tight labour market. The outlook for the next five weeks is for wage growth to continue moderating.

Housing market: House prices have shown signs of stabilisation in recent months, with some indicators pointing to a potential pickup in activity. However, the housing market remains subdued compared to pre-pandemic levels, with affordability constraints weighing on demand. The outlook for the next five weeks is for the housing market to remain relatively stable.

Business confidence: Business confidence has been mixed in recent months, with some surveys pointing to an improvement in sentiment while others suggest ongoing caution. The new Labour government's policy agenda will be a key factor influencing business confidence in the coming weeks.

Consumer sentiment: Consumer confidence has improved in recent months, with households reporting greater optimism about their personal finances. However, sentiment remains below pre-pandemic levels, reflecting ongoing concerns about the economic outlook. The outlook for the next five weeks will depend on the Labour government's policy announcements and their impact on household expectations.

Trade: The UK's trade deficit narrowed in Q1 2024, driven by a fall in imports. However, the trade balance remains in deficit, reflecting the UK's reliance on imports. The outlook for the next five weeks is for the trade deficit to remain elevated.

Rate cut countdown: BoE on hold as labour takes the reins

The Bank of England has maintained Bank Rate at 5.25% since March 2024, following a series of rate hikes that began in late 2021. The MPC has adopted a "restrictive stance of monetary policy" to combat inflation, acknowledging that "monetary policy needs to be restrictive for an extended period of time until the risk of inflation becoming embedded above the 2% target dissipates". However, with inflation now back at the 2% target, the debate within the MPC has intensified, with two members voting for a rate cut in June. The outlook for the next five weeks is for the BoE to remain on hold, with the MPC closely monitoring economic data and the new Labour government's policy agenda before making any changes to Bank Rate. The market-implied path for Bank Rate suggests a gradual decline in rates over the coming years, but the timing and pace of cuts remain uncertain. The May Monetary Policy Report projected that, conditioned on the market-implied path for Bank Rate at the time, CPI inflation would be 1.9% in two years' time and would fall below 2% from 2026 Q1 onwards.

Looming shadows: Key risks to the UK outlook

LFS data uncertainty (February 2024 - Present): The reinstatement of the Labour Force Survey (LFS) in February 2024, following a period of suspension due to quality concerns, has introduced significant uncertainty into the assessment of the UK labour market. The survey continues to suffer from low response rates, leading to volatile estimates and potential non-response bias. This makes it difficult to gauge the true state of the labour market and its implications for inflation. The Bank of England's Monetary Policy Committee is "continuing to consider the collective steer from a wide range of data to inform its view on labour market developments".

Red Sea disruption (January 2024 - Present): Geopolitical developments in the Middle East, including disruption to shipping through the Red Sea, have posed upside risks to global export prices, including for energy. While the impact on trade and oil prices has been relatively limited so far, a further escalation of tensions could lead to more significant disruptions. The Bank of England notes that "in an adverse scenario, oil prices could still increase significantly in the short run, alongside greater disruption to all types of trade flowing through the Red Sea".

Labour policy uncertainty (July 2024 - December 2024): The new Labour government's policy agenda, particularly regarding fiscal policy, regulation, and the labour market, will be a key source of uncertainty for the UK economy in the coming months. Businesses and investors will be closely watching for any signals of potential changes in policy direction and their potential impact on investment, hiring, and economic activity.

Conclusion: Charting a course through choppy waters

The UK economy is at a crossroads, with the new Labour government's policy agenda and the potential for interest rate cuts adding to the uncertainty surrounding the outlook. While there are signs of a recovery in activity, underlying growth remains subdued and inflationary pressures persist. The Bank of England is facing a delicate balancing act, seeking to support growth while ensuring that inflation returns to the 2% target sustainably.

Action points:

• Monitor the Labour government's policy announcements and their implications for fiscal and monetary policy.

• Pay close attention to upcoming economic data releases, particularly those relating to inflation, wage growth, and labour market tightness.

• Assess the impact of global economic developments, including geopolitical risks and the outlook for commodity prices, on the UK economy.

Key economic events:

• Week 30 (23rd July - 27th July): S&P Global/CIPS UK Manufacturing PMI (24th July), CBRT Policy Announcement (23rd July), NBH Policy Announcement (23rd July).

• Week 31 (30th July - 3rd August): BoE Interest Rate Decision (31st July).

• Week 32 (6th August - 10th August): Halifax House Price Index (9th August).

• Week 33 (13th August - 17th August): UK CPI Inflation (14th August), UK Unemployment Rate (15th August).

• Week 34 (20th August - 24th August): UK Retail Sales (23rd August).

• Week 35 (27th August - 31st August): UK GDP Growth Rate (30th August).

Sources:

• Office for National Statistics.

• Bank of England.

• S&P Global.

• Confederation of British Industry.

• GfK Group.

• BRC - British Retail Consortium.

• Nationwide Building Society.

• Halifax and Bank of Scotland.

• Trading Economics.

• Office for Budget Responsibility.