Is the UK still an economic outlier?

For much of this year, the UK has felt like an economic outlier. As the chart below shows, the inflation rate in the US and Euro area marched decisively downwards yet remained stubbornly high in the UK. Now, things finally seem to be moving in the right direction: at 6.8 per cent, UK inflation is far lower than its 11.1 per cent peak, and starting to close in on rates seen in other advanced economies.

Economic growth is also proving more resilient than expected. Just a year ago, the Bank of England released forecasts suggesting that the UK would enter an almost unprecedentedly long and deep recession. It didn’t materialise: recently released GDP figures showed that the UK economy grew by 0.2 per cent in the second quarter of the year — only a fraction slower than the eurozone. Then on 1 September came Office for National Statistics (ONS) data that upended received wisdom. Data previously showed that, as of the end of 2021, the UK economy was still smaller than it was pre-pandemic - a status that stood in contrast to all other G7 nations. But revisions made by the ONS now show the economy was in fact 0.6 per cent larger.

Following the encouraging GDP figures, economists at Berenberg asked in mid-August whether it was time to “turn less pessimistic on the UK”. They argued that “although Brexit has weakened supply potential, the UK economy has more or less kept pace with the wider trend for advanced economies over the past even years – with performance consistently beating overly pessimistic expectations”.

The economists added that “now the political situation is returning to normal, economic recovery combined with easing inflation pressures can underpin financial markets turning more positive (or at least less negative on the UK)”. If so, this should support gains in UK risk assets, and sterling, too,

But though things are better than they could be, the devil is in the detail. And as the table below shows, parts of the UK economy are looking a little too resilient. 

Wage growth (though also high in the US and EA) is currently running at 7.8 per cent in the UK. Understandably, this has been greeted as good news in many quarters: with wage growth now outstripping price growth, there is hope that the cost of living squeeze will finally start to ease. But economists are less optimistic. 

It goes without saying that this rate of wage growth is inconsistent with getting inflation back to the 2 per cent target. Last month, Ruth Gregory, deputy chief UK economist at Capital Economics, said that “with the labour market still tight and wage growth strengthening, we suspect services inflation will stay uncomfortably high for some time yet”. 

She added that “with wage growth and services inflation both stronger than the Bank had expected, it seems clear [it] has more work to do”. High wage growth could mean UK inflation stays higher for longer; and this means that interest rates will, too. Capital Economics expects the BoE to raise rates by another 25 basis points later this month, taking the base rate to 5.5 per cent. 

Crucially, that hike could come as policymakers at the Fed and the ECB mull a change of direction. Shamik Dhar, chief economist at BNY Mellon Investment Management, said that while the story for the past 12-18 months has been “quite consistent across the major central banks”, we may soon start to see diverging decisions. 

According to Dhar, “inflationary psychology” has not been punctured to the same extent in the UK, meaning tough debates between BoE rate-setters in upcoming meetings. Dhar said that any divergences in policy decisions will drive asset prices, adding that “these nuances that are emerging between central banks are going to become increasingly important for investors to watch closely”. The UK is no longer an inflation anomaly, but it could yet become a policy outlier.