UK now on course to avoid recession – although only marginal growth expected in 2023, says the EY ITEM Club Spring

• The EY ITEM Club now expects the UK economy to grow 0.2% in 2023, up from the -0.7% contraction projected in January’s Winter Forecast
• The UK economy is forecast to flatline in the short term and avoid two consecutive quarters of contraction – before better growth later in 2023
• House prices are expected to fall by around 10% peak-to-trough, although a serious correction is unlikely and the impact on the economy will be limited
• Historically high inflation should fall quickly in the coming months, with cheaper energy having a significant effect

LONDON, 17 April 2023: The UK economy is now expected to avoid both a technical recession and a calendar year contraction in 2023, according to the EY ITEM Club  Spring Forecast. The economy is expected to record 0.2% growth this year, which is a significant upgrade from the -0.7% contraction predicted in January’s  Winter Forecast. The improved outlook is largely thanks to better-than-expected GDP in Q4 2022 and the expected rapid easing of inflationary pressures.

The economy’s resilient performance also means the UK is likely to avoid the two consecutive quarters of contraction that would qualify for a technical recession.

With inflation likely to recede at pace, the Bank of England expected to begin cutting interest rates at the turn of 2023 and 2024, cheaper energy, and new investment incentives kicking in, 1.9% growth is still forecast for 2024. Growth is expected to reach 2.3% in 2025 (up from 2.2% in the Winter Forecast).

The economy is expected to flatline in the first half of 2023 as a result of the impact of still-high inflation and rising interest rates, the extra Bank Holiday in May, and a poor launchpad for growth from December’s fall in GDP. The outlook is set to improve from the summer onwards as the fall in wholesale energy prices helps push down inflation – faster than the EY ITEM Club expected in January – and eases the squeeze on households, while the fiscal loosening from the Spring Budget should start to take effect.

The UK economy is starting to turn a corner

Hywel Ball, EY’s UK Chair, says: “The UK economy seems to be turning a corner, albeit very slowly. Economic performance has been resilient, despite challenges in the latter half of 2022, but the significance of the upgraded outlook shouldn’t be overblown. While easing, the economy’s challenges haven’t gone away overnight: inflation is still in double-digits and energy prices remain historically high.

“However, perceptions matter and the fact the economy has been able to outperform expectations could help stir a revival in business and consumer confidence. Of course, there is still room for economic surprises, but the balance of risks has become a little more favourable than the last forecast. And while subdued growth this year is far from ideal, falling energy prices and inflation, an end to rises in borrowing costs, and growing confidence, mean the economy has a chance to shed some of the gloom it has accumulated recently.”

According to the EY ITEM Club, key downside risks to this forecast include a renewed increase in wholesale energy prices and the potential for tighter lending criteria in the wake of disruption in the global banking sector and rising central bank interest rates. On the other hand, an upside risk is the possibility that inflation may fall faster than expected, which could stoke more significant growth in the short term and see interest rates cut sooner.

Inflation, wage growth and interest rates all set to cool

The EY ITEM Club says that inflation is now forecast to end 2023 at just under 3%, down from January’s forecast of a little below 4%, taking more pressure off households and businesses. Across the year, inflation is expected to average 6.2% in 2023 (down from January’s 7.2% forecast) and 2.5% in 2024 (up from 2.3%). Inflation is currently forecast to fall back to the Bank of England’s 2% target in the second half of 2024.

Pay growth should also slow, with average earnings growth for 2023 forecast to be 4.2%, down from 6.4% in 2022. This reflects falling inflation expectations, the emergence of some slack in the labour market, and a fall in job-to-job moves (which tend to lead to higher pay) from the unusually high levels seen during and immediately after the pandemic.

Calendar year wage growth is still forecast to fall short of inflation in 2023, with annual average wage growth not expected to be higher than annual average inflation until next year (when wages are predicted to grow 2.8%). However, the EY ITEM Club expects wages to start to outpace inflation from this summer onwards.

In increasing Bank Rate to 4.25% in March, the Monetary Policy Committee (MPC) was faced with a combination of stronger-than-expected growth and employment, but underlying inflation in-line with expectations and pay growth that was slightly weaker than anticipated. This combination makes predicting the path of Bank Rate in the short-term difficult. The EY ITEM Club expects the MPC to deliver one more rate increase in May to 4.5%, before rates start to be cut at the end of 2023, with reductions continuing in 2024.

Martin Beck, Chief Economic Advisor to the EY ITEM Club, says: “Historically high inflation has been a key challenge for the UK economy recently, with consumer confidence and spending power stifled by high energy costs and the rising cost of living. Inflation is set to cool, however, and the public’s inflation expectations are falling fast. Falling energy prices, continued government support through the Energy Price Guarantee, and earlier price rises falling out of the calculations should all help pull inflation down this year.

“Despite challenges in the global banking sector and falling inflation, another rate rise at May’s MPC meeting is probably more likely than not following a better-than-expected economic performance. Indeed, a stronger economy might mean inflation takes longer to cool down this year. On balance though, we think Bank Rate should start to come down from this winter.

“The emergence of stresses in the global banking sector have brought to the fore an additional channel of risk between rising interest rates and the real economy. UK credit conditions could tighten if global financial volatility were to have an impact on banks’ funding costs and lending appetites. This would create another headwind for the housing market, business investment, and consumers’ looking to use debt to compensate for the squeeze on their spending power.”

Consumer and jobs outlook showing modest signs of improvement

In line with expectations for inflation and energy bills to fall faster this year, the EY ITEM Club now forecasts consumer spending to fall just 0.3% in 2023, up from the 1.4% contraction predicted in January – although this would still be a significant decrease from 2022’s 5.6% growth. A rise of 1.8% is forecast in 2024, with a further increase of 2.4% expected in 2025.

Despite the upwards revision in the EY ITEM Club Winter Forecast, relatively high inflation by the standards of recent decades, the freeze in income tax thresholds, and the impact of rising debt servicing costs on mortgages, credit cards and other borrowing underpin the continued expectation that consumer spending will fall this year

With job creation remaining solid, the EY ITEM Club’s Spring Forecast projects only a modest rise in unemployment and expects the rate to peak at just over 4% (down from January’s forecast peak of almost 5%). This is mainly due to the improved GDP outlook, while continued recruitment difficulties in some sectors add to the likelihood that businesses will choose reduced hours or moves to part-time working ahead of cuts in staff numbers. The measures to boost participation in the workforce announced in the Budget may also keep the jobless rate down at the margin.

Peter Arnold, EY UK Chief Economist, adds: “The key domestic uncertainties around the economy relate to how far households will use the savings built up over the pandemic to support spending amid falling real wages, and whether rates of economic inactivity will return to their pre-pandemic levels.

“So far, there have been only limited signs of consumers opting to cushion the impact of inflation on their incomes by borrowing more or using their savings – and there are reasons for caution to continue. Falling house prices will reduce homeowners’ wealth, while those with mortgages face a significant rise in monthly outgoings when their current fixed-rate deals start coming to an end. But better economic news should be a boost to consumer confidence, while the return of real wage growth later this year will also help.”

House price falls to continue – but economic impact limited

The EY ITEM Club Spring Forecast continues to predict a sustained fall in house prices, with a peak-to-trough decline of 10% expected over the next two years. While the projected fall in prices will likely weigh on construction activity, particularly housebuilding, as well as affecting the sales of household goods, the changing influence of the property market on consumer spending means it is unlikely this fall in values will have a major adverse impact on the economy.

Business investment outlook improving

Despite business investment’s poor performance in recent years, the EY ITEM Club Spring Forecast presents some reasons for optimism. These include a better outlook for GDP this year, greater clarity in the trading relationship between the EU and UK, and, most importantly, the effect of the temporary full-expensing capital allowances announced in the Budget. This will enable businesses to reduce their taxable profits by 100% of the cost of their investments in plant and machinery for three years from April 2023.

The EY ITEM Club now forecasts that business investment will fall 0.3% this year, a little less than the 0.8% fall previously predicted, before increasing 2.3% in 2024 as the effect of the investment incentives kicks in.

Hywel Ball comments: “Business investment has underperformed the wider economy in recent times, with inflationary pressures and supply chain issues among a range of unprecedented headwinds weighing on capital spending. However, the economy’s resilience against a challenging backdrop, as well as recent policy announcements, should support businesses and investment going forward. It’s vital that businesses plan for different scenarios so that they have the confidence to follow through on investment plans amid changing circumstances.”