Consumer spending is subject to conflicting forces
There is no guarantee that households will come to the aid of the economy by spending their savings. Fears of a long-term squeeze from expensive energy and higher prices for other essentials may see many consumers continue with more frugal habits learned during the pandemic. Some households lack access to credit and the option of smoothing their spending in the face of real-income falls. Conversely, near-record low unemployment (3.8%) and continued strong demand for workers could encourage some consumers to spend more. Therefore, the prospects for household spending are mixed.
Concerns around inflation, supply chains and geopolitics weigh down on business investment
Turning to business investment, the outlook is rockier. Following an underwhelming recovery in 2021, the temporary super-deduction tax incentive should support a modest pickup in business investment this year. But any rebound will be held back by geopolitical uncertainty, new supply chain issues and rising capital-goods prices. We do not expect business investment to return to pre-pandemic levels until the end of 2022.
The challenging blend of soaring oil prices, supply-chain bottlenecks and surging inflation has drawn some comparisons with the ‘Great Inflation’ of the 1970s, but these might be overexaggerated. Inflation was already high and rising before the 1973 oil shock, and the UK economy is now much less energy-intensive. Also, employers’ relatively greater power reduces the risk of a wage-price spiral and today’s transformed monetary policy should help to maintain persistently high inflation. Whilst there is still a risk of a longer-term structural shift towards higher inflation, it is fairly remote.
The Monetary Policy Committee will take a cautious approach in raising interest rate
The unexpectedly rapid rise in inflation and concerns about the effect of a tight jobs market on wages mean the Monetary Policy Committee (MPC) will probably continue to raise interest rates. But the pressure on demand from the surging costs of energy and other essentials mean that it is likely to approach this cautiously. We now expect one further 25bps (basis points) rise this year, taking Bank Rate to 1.25% by the end of 2022 — less hawkish than the 2%-plus that investors were expecting as of mid-April.
This more dovish approach has been foreshadowed recently by more cautious language from the MPC and downbeat growth forecasts from the Bank of England (BoE) even before the war in Ukraine. Monetary policymakers will not want to trigger a recession by overreacting to the supply shock. Additionally, with the MPC intending to start selling gilts purchased under the Quantitative easing (QE) programme now that the Bank Rate has reached 1%, the Committee may be wary about raising rates too fast — given the uncertainty over the effect ‘quantitative tightening’ may have on the economy.