Will the UK fall into a recession?

The Bank of England has warned that the UK economy could enter recession this year as increasing energy prices push inflation past 10%. Photo: Bank of England Governor Bailey

>> UK recessions risks on the rise

Policymakers are understandably reticent to forecast recessions. This is partly because it looks as if their policies have failed, and partly because such talk could deflate confidence and cause a recession that might not have otherwise occurred, or deepen one that’s already underway.

Unusually, the Bank of England admitted that a recession is very likely even if, as Governor Bailey put it, the forecast for growth to fall next year does not necessarily meet the strict criteria of a recession. But, as the saying goes, if it looks like a duck, swims like a duck and quacks like a duck, then it probably is a duck. And, right now, the UK economy has all the signs necessary to show that, even if growth does not contract for two consecutive quarters (which is the customary definition of a recession), it is effectively going into a recession, if it is not there already.

But recession is happening with inflation rising to over 10% on the Bank’s estimate and that clearly makes things stagflationary, not just recessionary. Admittedly, much of the reason for the projected rise from the current 7% inflation level to 10%, or more, is due to the upcoming hike in household energy bills in October when the next change in the price cap for energy prices occurs. But even so, there are sufficient underlying pressures to mean that inflation can still be considered a major problem.

One caveat is that the Bank’s forecasts for the economy are conditioned on market expectations for base rates and energy prices. On the former, the market has been pricing base rates to rise up to 2.5% but the Bank’s forecasts suggest that this will contribute to sub-target inflation levels over the longer-term. The inflation forecast for 2024 was taken down by the Bank to 1.5% from 1.75%; even further below the 2% target.

The Bank is effectively saying that if it hikes rates as the market is anticipating it will slow the economy too much and take inflation down too far. Now that’s a very contentious point and we certainly think that inflation will be more stubborn than the Bank suggests. Nonetheless, given that the market is now quickly lowering its interest rate forecasts, it could be the case that future Bank forecasts show a bit more growth and a bit more long-term inflation than the ones presented yesterday.

But this is clutching at straws. There is no getting away from the fact that forecasts for inflation of over 10% and economic contraction are dire. Even if things turn out better than this, they will still be pretty terrible and Mr. Steve Barrow, Head of Standard Bank G10 Strategy doesn’t think that they will be much better. He has adjusted his base rate forecasts to show a lower peak than before. The base rate is now seen rising twice more, to 1.5% from where the Bank will pause through the rest of this year and through much of 2023.

The Sonia curve is predicting that market rates will start falling in Q4 next year, although the curve is still some way from suggesting base rate cuts yet. Mr. Steve Barrow suspects that the Bank’s dire forecasts will make the market think more about rate cuts later next year but he remain concerned that inflation will prove too persistent.

In fact, when the worst of the economic downturn is over, the Bank could still need to lift base rates a bit further to stamp down on inflation. As for sterling, its quite hard to remember a more damning economic forecast from the Bank before. As said at the start, policymakers are reticent to forecast recessions, but stagflation is another level entirely, and we have to wonder whether our sterling outlook for relatively modest losses against the dollar and broad stability against the euro is still relevant.

“We were looking for sterling/dollar to slide to the 1.15-1.20 range and then recover. We will stick with this view for now but stress that all the risks seem to lie to the downside”, Mr. Steve Barrow said.