Softer growth, inflation and Brexit
12 June 2018
The UK economy has performed slightly worse than we expected at the start of the year. Activity in the first quarter was extremely weak, with quarter-on-quarter growth of just 0.1%. However, we think that much of this weakness was a weather-related phenomenon. We are therefore relatively optimistic about the prospects for second quarter growth, forecasting an increase in GDP of 0.5%, as pent-up demand is realised. The data so far has been broadly consistent with this bounce-back, with the various PMI surveys (see chart 4), retail sales, consumer confidence and credit data, all recovering nicely. However, the fall in industrial production in April was a disappointing start to the quarter (see chart 5), while the trade picture is also quite downbeat, with the trade deficit widening from £3.2bn in March to £5.3bn in April. Overall, we expect the economy to grow by 1.4% this year, followed by 1.5% next year and the year after.
The inflation profile this year has also been a little softer than we had expected, falling more rapidly towards the Bank of England’s target. This largely reflects slightly less pass-through into domestic inflation from past sterling weakness. However, the recent increase in oil prices will put upward pressure on the energy component of the inflation basket. At a minimum, this will slow the current decline in inflation towards target, and may even see year-on-year inflation tick-up briefly over the summer. We expect inflation this year of 2.3%, down from 2.7% last year. The domestic inflation fundamentals in the UK appear to be firming slightly. Nominal wage growth is creeping higher as the labour market continues to tighten. After a jump in labour productivity growth in the second half of 2017, Q1 2018 saw productivity fall. While the underlying trend is not completely clear, we forecast trend growth of around 1.5%. As wage growth pushes further above this rate, unit labour costs will rise more quickly, generating greater domestic inflationary pressures. We expect the Bank of England to increase Bank rate just once this year, in August, slightly less than we had originally anticipated, reflecting the marginally weaker growth and inflation paths.
On Brexit, our expectations have shifted to a slightly ‘softer’ outcome. In our baseline forecast, the UK enters into a customs union with the EU. This reflects a subtle hardening of the EU’s negotiating position over the Irish border, and shifts in UK domestic politics. The EU has made clear that it does not believe any of the UK’s preferred customs arrangements (maximum facilitation or a customs partnership) can solve the crucial Irish border issues - at least for the foreseeable future. As such, the UK will probably need to commit to customs union membership (either by falling back on a supposed “backstop” or by explicit agreement) to reach an exit deal. Meanwhile, the Labour Party has committed to a customs union, which means there is probably now a cross-party coalition big enough to defeat the government in the Commons on exiting the customs union. The timeline for agreeing the final deal seems to have slipped slightly. Originally, the June EU submit was expected to deliver significant progress on solving various issues, before the final deal was then signed-off in October. It now appears that most of the work will now be postponed to the October summit at the earliest.