High interest rates weigh on GDP, but the UK should still avoid recession, says the EY ITEM Club

EY ITEM Club Autumn Forecast - October 2023

Following a better-than-expected start to the year, GDP growth expectations for 2023 have been upgraded slightly from 0.4% in July’s Summer Forecast to 0.6%. Meanwhile, the EY ITEM Club’s 2024 GDP growth forecast has been nudged down from 0.8% to 0.7% thanks to the lagged effects of the recent interest rate rising cycle. A likely end to rate increases at the Monetary Policy Committee’s (MPC) last meeting, combined with falling inflation and a return to real pay growth, should keep the economy from falling into recession.

Inflation is now expected to fall slightly faster than was forecast in the summer, and could reach 4.5% by the end of 2023, before hitting the Bank of England’s 2% target during the second half of 2024. In July, the EY ITEM Club expected inflation to end 2023 at just under 5%. Bank Rate is not expected to increase beyond its current level of 5.25%, and the EY ITEM Club says the MPC may start to cut Bank Rate from May 2024.

The economy is still forecast to grow 1.7% in 2025 as lower inflation lifts real incomes and interest rates are cut.

Hywel Ball, EY UK Chair, says: “The cost of debt is set to be the biggest headwind for the UK economy over the next 12 months, with consequences for both businesses and consumers. But while high interest rates will weigh heavily on growth, there are still signs of resilience from which we can take positives. Inflation is heading in the right direction, average wages are rising in real terms once more, and household and corporate balance sheets remain unusually healthy.

“While the UK may have lagged some of its global peers in its economic recovery from the pandemic – despite upwards revisions to GDP data – this suggests there is room for catch-up growth. Most encouragingly, the recent strength of business investment, which had been disappointingly subdued for some time, perhaps signals that the economy’s growth potential may be reviving. There’s no getting away from the fact that growth will be limited in the short-term, but there are reasons for optimism for next year and beyond.”

Higher interest rates a positive and a negative for consumers

The EY ITEM Club forecast presents a mixed picture for consumer spending, which is expected to benefit from several supports. Although pay growth is expected to ease, inflation should decline more quickly. Falling energy bills, easing food price inflation and weaker pipeline price pressures mean inflation is predicted to average 7.4% this year (down from July’s 7.6% forecast), before falling to 2.9% in 2024 (down from 3.4%) and 1.7% in 2025.

Meanwhile, the EY ITEM Club estimates that higher interest rates have, so far, been a net positive for household incomes with the income boost from higher rates on savings accounts exceeding the extra amount spent on mortgage interest payments. But this picture is set to reverse as deposit rates stabilise and more and more borrowers roll over fixed rate mortgages onto higher rates.

Consumers will also feel pressure from higher oil prices, the combination of frozen income tax thresholds and still-high inflation, and a deteriorating labour market. Unemployment is now forecast to peak at 4.8% next year, up from July’s forecast of a 4% to 4.5% peak in 2023.

Taking these supports and pressures into account, consumer spending is now expected to grow 0.7% this year (an upgrade from the flat 0% expected in the Summer Forecast), another 0.7% in 2024 (slightly up from 0.6%) and 1.7% in 2025 (no change).

Martin Beck, Chief Economic Advisor to the EY ITEM Club, adds: “While recent industry surveys have been fairly gloomy about the UK economy, there have been enough positive developments, including upwards revisions to past data, to lift the mood music and reduce the danger of recession becoming a self-fulfilling prophecy. There are still prominent risks to the forecast though, including potential volatility in both oil and gas prices and tighter financial conditions. And, with an election approaching, the future path of government fiscal policy isn’t clear beyond 2025, presenting a significant unknown to the longer-term forecast.”

The EY ITEM Club continues to expect house prices to fall by around 10% from their highest to lowest points, with a flatlining expected in 2023 before a 4% fall in 2024 as high borrowing costs apply downward pressure on demand. The market is still expected to avoid a serious price correction, helped by forbearance from lenders and the fact that the ratio of house prices to average incomes has fallen.

Business investment continues to offer encouragement

The EY ITEM Club notes that business investment grew significantly in the first half of 2023, but that high interest rates and a low-growth economy mean the recent pace of investment growth is unlikely to be sustained. Nonetheless, given the strength of the improvement at the start of the year, the EY ITEM Club has upgraded its 2023 business investment growth forecast to 5.9% from the 1.4% growth expected in the Summer Forecast. This would be the fastest rate of growth since 2016, excluding the post-pandemic bounce back seen in 2022.

The EY ITEM Club adds that, despite higher interest rates, deleveraging by UK companies and relatively limited refinancing needs for market-based debt suggests that, on the whole, UK companies won’t face serious financial stress. The EY ITEM Club expects a modest fallback in investment in 2024, with a contraction of around 0.5%.