But new risks are brewing. Banking sector strains – primarily in the US – are likely to hit growth, with knock-on effects in the UK and elsewhere. Yet that hasn’t stopped global central banks, including the Bank of England, from hiking interest rates; that may complicate matters still.

The UK economy grew by 0.1% in Q4 and by 0.3% in January, primarily due to a strong services sector. There was some weakness in manufacturing, which is still plagued by thin order flow, poor household demand and high borrowing costs. Construction also contracted.  

Fast-moving indicators suggest that growth momentum improved in Q1. UK business activity increased, driven by services, although the UK composite Purchasing Managers’ Index (PMI) eased from 53.1 in February to 52.2 in March. The new orders balance rose to 54.4 – its joint-highest level in a year – thanks to higher demand both at home and abroad. 

As we’ve said before: while it’s encouraging that parts of the economy are improving, PMIs exclude retail, construction, and public services, all of which are under pressure. But grains of salt aside, businesses haven’t been this upbeat about the 12-month outlook since March 2022. Why? Consumers are buying what retailers are selling. Indicators of household spending are gradually improving, with CHAPS card spend data recovering in Q1 after plummeting to pre-pandemic levels since their Christmas peak. Retail sales, including petrol, rose by 1.2% month-on-month in February, above the consensus expectation of 0.2%. 

Household finances are still under pressure as inflation continues to outpace wage growth. What’s more, recent strains in the banking sector suggest mortgage rates will stabilise at their current high level rather than fall. As a result, households have finally begun to draw upon their pool of savings. 

Businesses look set to face several challenges in Q2. Government support for energy bills will become less generous. Most notably for many, the main rate of corporation tax will rise from 19% to 26%. Overall, the muted recovery in household spending, high borrowing and mortgage costs, and anticipated modest staff cuts suggest economic headwinds may blow for some time yet.

UK card spending recovers somewhat in Q1

Consumer Price Inflation (CPI) unexpectedly rose from 10.1% in January to 10.4% in February, driven by seasonal factors such as higher food prices: food inflation hit 18.2% in February – a 45-year high. Clothing inflation also rose. These spikes are expected to reverse as the weather improves and energy costs fall. 

However, core and services inflation also rose, with core CPI, which excludes volatile items such as food and energy, up from 5.8% in January to 6.2% in February, and services inflation – an indicator of domestic price pressures – up from 6.0% to 6.6%. 

We still think inflation should fall sharply in the coming months, with electricity and natural gas prices likely to drop by the end of the year. Base effects linked to the anniversary of Ukraine’s invasion suggest that motor fuel inflation should fall. Core goods inflation should ease due to the slowdown in producer output price rises, the collapse in shipping and commodity costs and excess inventory. And forward-looking data point to slowing services inflation, with domestic wage pressures having slowed somewhat in recent months.

While it’s too early to declare victory over price pressures, the inflation backdrop does seem to be on the cusp of improving markedly.  

OBR forecasts a steep fall in inflation in 2023

The UK labour market is no longer tightening – the unemployment rate remained unchanged at 3.7% in the three months to January. Better still, employment growth remained resilient in the face of rising interest rates.

However, there are challenges ahead. In particular, vacancies fell further in February, and are now 13% below their peak last April. Surveys point to growing cautiousness among firms, which are posting fewer vacancies, reducing working hours and initiating redundancies (albeit modestly) due to economic uncertainty. 

Wage growth already appears to be slowing. Annualised month-on-month growth in private-sector wages, excluding bonuses, was just 1.2% in January – well below the average of 6.9% in the previous 12 months. Real wage growth looks grim: average real wages fell by 2.5% in the year to January. 

Overall, the labour market has remained resilient so far. We expect it to be challenged as 2023 progresses, but it is likely to remain relatively strong. Consensus estimates are for a peak unemployment rate of 4.6%, well below previous highs in the early 1990s and in the aftermath of the 2007-08 financial crisis, when it hit 8.4%. 

Private sector wage growth has slowed significantly in recent months

The Bank of England hiked its key interest rate by 25 basis points (bp) to 4.25% on 23 March despite the turmoil in the banking sector. The Fed and European Central Bank (ECB) also raised rates. 

But overall, markets still believe the banking sector’s problems mean fewer rate hikes going forward as concerns about financial stability will feature more prominently in rate decisions. For the UK, markets are pricing in one more hike and then cuts from Q1 next year.

For now, the Bank of England is confident that there should be no major domestic financial ramifications from the recent banking crisis. With UK banks proving resilient to recent events, impacts on credit availability and knock-on macroeconomic effects should be limited. 

By contrast, the US is likely to see more material credit tightening. The expected path of UK interest rates has been volatile due to the recent banking turmoil and disappointing inflation data. 

Latest market-implied curve points to peak rate of 4.50% but expectations of a rate cut have come forward

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