Meanwhile, a relatively tight labour market means the perceived risk of job losses is low. But again, there are indications that slack is developing. So far, that’s not led to a cooling in wage growth. 

With inflation falling and earnings higher than expected, household income dynamics are set to improve in the second half of the year, although that’s unlikely to materially change the trajectory of the economy. 

What are the implications for monetary policy? The end of the tightening cycle is approaching, but the Bank of England has a delicate balancing act in forcing down inflation without driving the economy into recession.

The UK economy shrank by 0.1% in May – but less than the 0.3% contraction that had been expected. The drop was primarily due to lower production, which was down by 0.6% in May. The construction sector also shrank by 0.2% as the higher cost of borrowing continues to impact demand for new houses. Meanwhile, the services sector stagnated.

Higher interest rates seem to be hitting the economy. Business surveys such as the Purchasing Managers’ Index (PMI) suggest that the private sector’s recovery is losing steam: the PMI flash composite index fell from 52.8 in June to 50.7 in July, its lowest level since January. And the drop in the composite orders index – a forward-looking component— from 51.6 in June to 50.0 suggests that the trend will not improve soon.

Indicators of business confidence are painting a mixed picture. The Decision Maker Panel survey shows a lower proportion of firms are reporting high uncertainty, but according to the latest PMIs for July, business optimism dropped for a third straight month.

Indicators of consumer spending are also mixed. On one hand, retail sales volumes were up 0.7% month-on-month and 0.4% quarter-on-quarter in Q2, driven by one-off factors. This suggests that overall, the economy is proving resilient to high inflation and rising interest rates. On the other hand, the CHAPS card aggregate spend index fell slightly in June.

Housing market activity remains soft, even though the recent surge in mortgage interest rates has started to reverse. Historically high rates are leading many to prioritise debt repayments – lump-sum mortgage repayments remain well above average levels. 

Looking ahead, the economy is likely to regain some momentum in H2 as falling energy prices and stabilising goods prices boost households’ real disposable income. That said, there is still considerable uncertainty stemming from the interplay of higher mortgage payments and people’s desire to rebuild savings buffers and deleverage amid higher interest rates. Overall, growth remains finely balanced. Consensus expectations are still for muted growth this year, followed by a pick-up in 2024. 

The recovery in UK business activity is losing momentum: services are holding up, but manufacturing continues to contract (PMIs)

Having plateaued close to 40-year highs since last autumn, it now finally looks as if UK inflation has started to fall. UK consumer price inflation was down from 8.7% year-on-year in May to 7.9% in June, well below the consensus expectation of 8.2% and the lowest reading since March 2022. 

Lower fuel prices were the main reason for the fall in the headline rate, down by 2.7% between May and June. Food inflation also fell but is still high at 17.3%.

Core inflation, which excludes components like food and energy, eased from 7.1% in May to 6.9% in June, while services inflation fell from 7.4% to 7.2%. Services inflation is of high interest to the Bank of England’s Monetary Policy Committee (MPC) as this measure is closely linked with domestic inflationary pressures.

Consumer Price Inflation (CPI) looks set to continue to fall over the coming months as most factors that have driven inflation over the past couple of years are moderating. Both input and output producer price inflation are now falling, although high services inflation remains a cause for concern. The Bank of England’s Decision Maker Panel Survey reported firms intend to raise prices by an average of 4.9% over the next 12 months, the lowest figure since February, while an Office for National Statistics business survey shows that just 15% of businesses intend to increase prices in August, well below the 22% average of the past few months. Falling household and business inflation expectations are also providing relief. 

Inflation is (mostly) starting to subside

Signs that the labour market is easing are becoming more evident. The three-month average headline unemployment rate hit 4.0% in May, up from 3.8% in the three months to February. Redundancies are historically low but rose by 0.2 per 1000 employees in May from the previous quarter to 3.3 per 1000. That said, wage growth has been higher than expected: headline average weekly earnings were up 7.3% year-on-year in May, unchanged from April’s upwards-revised rate.

Labour demand is cooling significantly, with the number of full-time employees down by 14,800 between April and May. The vacancies-to-unemployment ratio fell from 0.83 in April to 0.77 in May, while the number of vacancies was 85,000 lower in the three months to June than the previous three months – the biggest drop since 2009. 

Meanwhile, labour supply is picking up. In the three months to May, the UK’s economic inactivity rate was 20.8%, 0.2 percentage points lower than the previous quarter. What’s more, immigration is picking up swiftly and total staff availability increased at its fastest pace since December 2020 between April and May. This was thanks to a rise in the number of job seekers due to redundancies and reduced hiring activity. 

While the labour market is weakening somewhat, it is likely to remain an area of relative strength, with any rise in unemployment likely to be modest. 

Wages continuing to increase (% wage increases)

Against a backdrop of elevated inflation and wage growth, the Bank of England hiked rates by 25 basis point to 5.25% at its 3 August meeting, its 14th consecutive hike.

Rate hikes finally appear to be having an impact on inflation. However, markets still expect the rate tightening cycle to carry on until early 2024. That’s because while headline inflation seems to be easing, we are yet to see a significant softening in underlying inflationary pressures in the economy – in other words, lower core and services CPI. The Bank of England has adopted a data-dependent approach to further hikes.

When could rates be cut? The Bank of England’s updated guidance suggests that rates will stay “sufficiently restrictive for sufficiently long”. In other words, rates could remain higher for longer if inflationary pressures persist. Managing the trade-off between persistently high rates and a weak growth environment will remain difficult. 

Financial markets now expect rates to peak below 6.0% (market pricing for Bank Rate)

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