Will the UK be an economic outlier again this year?

If one thing dominated the domestic economics columns last year, it was inflation. And with good reason: for a huge chunk of 2023, the UK looked like an outlier on this front. Inflation proved stubbornly elevated – and at one particularly hairy point in March, our inflation rate was more than five percentage points higher than in the US. But as the chart below shows, price growth is now converging. Can the UK economy continue to move back in line with its peers this year?

Data should keep converging

The OECD published updated forecasts in November, and now expects the UK economy to grow by 0.7 per cent this year. Although weak compared with the OECD average of 1.4 per cent, this doesn’t look so bad when compared with growth forecasts for the German (0.6 per cent) and French (0.8 per cent) economies. 

Things are promising on the inflation front, too. The organisation expects UK inflation to fall to 2.5 per cent by the end of 2024 – only slightly higher than the 2.2 per cent rate it forecasts for the US. Nevertheless, Bank of England (BoE) rate-setters made some decidedly hawkish comments in their December meeting, stressing that “the committee continues to judge that monetary policy is likely to need to be restrictive for an extended period of time”.

If inflation is heading downwards, why are policymakers so concerned? 

The biggest issue looks to be wages. According to Jennifer McKeown, chief global economist at Capital Economics, pay deals in the UK are still “worryingly high”. Data shows that while annual pay growth has fallen to 3.4 per cent in the US and 5.2 per cent in the euro area, it is 7.2 per cent in the UK. Although some unions elsewhere have negotiated double-digit pay deals, these are usually spread out over several years, meaning a big rise upfront, followed by smaller increases in subsequent years. In the UK, deals are typically negotiated for one year, and McKeown thinks that “we cannot draw the same comfort about the future pace of pay growth that we can for several other advanced economies”, as a result. 

The BoE also suspects that the UK’s structural rate of unemployment has risen since the pandemic, meaning that if we want to avoid the risk of inflation accelerating, we will have to stomach a higher unemployment rate. Accordingly Goldman Sachs economists think that “the UK’s growth-inflation trade-off” is worse than in other developed markets – and the BoE’s chief economist seems to agree. In late November, Huw Pill warned that “the weakening of activity is not as associated with the easing of inflationary pressures” as we might expect, in part because of supply-side issues. 

This will make timing rate cuts exceptionally difficult – and could give UK rate-setters cause for caution. Despite better-than-expected December inflation figures, economists still anticipate that the BoE will be slower than either the Fed or the European Central Bank (ECB) to cut rates in 2024. 

Underlying eccentricities remain

Headline figures belie an unusually challenging backdrop when it comes to public finances, too. The debt-to-GDP ratio has risen in the UK since the pandemic – although this is hardly unusual, as the table shows. Goldman Sachs economists think that the government’s fiscal rules should leave the UK’s debt position looking “broadly similar to the US and euro area” over the years ahead.

But not all debt is created equal. Index-linked gilts account for a quarter of UK government debt stock, compared with 12 per cent for Italy, the next-largest issuer. This is costly at a time of high inflation, and RPI inflation, to which coupon payments are linked, is still running at 5.3 per cent. According to Goldman Sachs analysts, this is only one of the UK economy’s “underlying fiscal vulnerabilities”. In 2024, we will still have to contend with losses associated with quantitative tightening and the high proportion of debt held by foreign investors. 

This all leaves the UK with some underlying economic ‘eccentricities’, particularly when it comes to the labour market and public finance position. Even if headline figures do start to converge, these quirks won’t disappear in 2024.