Why is the British economy falling behind?

The International Monetary Fund expects the UK to be the only large economy to shrink in 2023 – performing even worse than Russia. It’s time to examine the key contributing factors

The British economy will contract by 0.6% in 2023, the International Monetary Fund (IMF) believes. According to its World Economic Outlook Update, published on 31 January, that will make the UK the only large economy to shrink this year. Even international pariah Russia has better prospects, the IMF believes.

The forecast is another blow to UK plc’s global reputation. Only a few weeks ago, many analysts thought that things might be looking up at last after several key economic indicators improved.

For instance, GDP unexpectedly rose – albeit slightly – in November, making it possible that the country will avoid recording a technical recession (two successive quarters of contraction) when the full 2022 figures are available. Unemployment remains about as low as it’s been since records began. Our equity markets are also on the up, with the FTSE 100 index nearly returning to its all-time peak last week.

After the inflation rate dipped a little in December, the Bank of England’s governor, Andrew Bailey, called it “the beginning of a sign that a corner has been turned”. He added that there was “more optimism now that we’re going to get through the next year with an easier path”. Meanwhile, the Bank is expected to upgrade its economic outlook on 2 February, revising its forecast for an eight-quarter recession to a “shorter and shallower” downturn.

So why is the IMF – along with many other international voices – striking such a downbeat note?

The answer is that the UK is facing a unique combination of problems. As Mark Carney, the Bank’s previous governor, noted this week, the triple pressures of energy price inflation, the pandemic and Brexit have “weighed on the economy”, leaving us trailing comparable countries and forcing policy-makers to balance getting inflation under control with keeping the downturn bearable.

GDP growth: negative signs

Many observers were surprised when GDP rose by 0.1% in November, making it more probable that Q4 will record positive growth overall when the figures are revealed in February. This makes it unlikely that the UK is already in a recession.

But output shrank by 0.3% during the preceding three months, meaning that the UK economy had the worst growth of all G7 members last year. It is still 0.7% smaller than its pre-recession level.

Almost no one disagrees with the IMF’s verdict that the UK will enter a downturn in 2023, but its likely length and depth are both moot. The British Chambers of Commerce  predicts a recession lasting until the end of the year, citing a “sharp fall in household spending” thanks to housing and energy price inflation, plus falling real wages. According to the Office for Budget Responsibility (OBR), the economy is likely to shrink by 2% before an upturn. It believes that a resultant 7% decline in living standards will wipe out the previous eight years of growth.

Inflation: barely under control

Managing inflation, which started rising in late 2021 and was then fuelled by Russia’s invasion of Ukraine, is considered key to solving the UK’s economic woes. Although inflation, as measured by the consumer price index, dipped slightly in December for the second month running, it is still more than eight percentage points above the Bank of England’s target of 2%.

Even this modest fall could be negated quickly if international market movements lead to another increase in petrol and diesel prices. Meanwhile, the UK remains heavily dependent on natural gas for domestic heating, which is likely to make inflation ‘stickier’ here than it is in several other economies.

“We’re not seeing the sort of drops in inflation that they’ve been getting in the US,” observes Giles Coughlan, chief market analyst at the HYCM Capital Markets Group. US inflation peaked in June 2022 at 9% and has since eased to 6.4%.  

UK wage growth, which stands at 6.4%, could fuel the fire, he adds. “As long as prices keep rising, workers are going to ask for higher wages. If workers are asking for higher wages, then companies are going to charge higher prices. Then you have the wage-price spiral. Once that’s in an economy, it’s very difficult to get it out.”

Interest rates: a tricky balancing act

Central banks in many economies have increased the cost of lending in their efforts to control inflation. The Bank of England has been more aggressive than most, increasing the base rate nine times last year. That was partly down to the impact of Kwasi Kwarteng’s disastrous mini-budget in September, which sparked chaos in the markets.

The Bank’s base rate is 3.5%, the highest level in 14 years. It’s widely expected to rise again this week to 4%. The rate is likely to keep climbing until at least the end of the year. As well as making life more difficult for both mortgage-holders and renters, these increases have been putting severe constraints on business investment.

“The only thing the Bank can do to control inflation is to keep hiking interest rates more aggressively, but that’s going to result in greater hardships and drag down growth. But how else do you cool demand?” Coughlan says. “That’s what the Bank is going to have to wrestle with. It really can’t win here.”

Unemployment: predicted to surge

Another factor that would cool demand would be a significant increase in unemployment, which helps businesses to save on wage costs. But the labour market is tight, with record numbers of both job vacancies and people in work. The government is also working on proposals to encourage economically inactive people – including carers, the long-term sick and students – back to work.

Despite all this, the OBR predicted in November 2022 that unemployment would increase by 50% (equivalent to about 650,000 people) by mid-2024. This was a significant change from its March forecast, which predicted that the rate would remain largely unchanged until 2027. 

Consumer spending: more belt-tightening ahead

Inflation has shrunk British consumers’ disposable incomes severely since the end of 2021, but the situation is widely expected to deteriorate even further. The latest in a long-running series of surveys of consumer confidence by market research firm GfK has found that sentiment in the UK is even weaker than it was during the depths of the global financial crisis and the pandemic.

GfK’s index takes into account people’s feelings about their own prospects and those of the economy. Joe Staton, its client strategy director, says that the results show “high levels of pessimism over the state of the wider economy”, adding that the decline that researchers have detected in the number of people planning big purchases soon is a particularly bad sign.

The FTSE 100’s revival: no silver lining

Despite consumer pessimism, many blue-chip companies have been performing strongly. Several big high-street names, including Next, Boots and Sainsbury’s, recorded bigger profits than expected in the run-up to Christmas.

Meanwhile, the FTSE 100 index has been getting close to its all-time peak. Shares in banks and consumer goods firms are particularly buoyant. But analysts warn that this still isn’t necessarily good for the whole country. 

As Coughlan points out: “A lot of the FTSE 100 earnings come from overseas. These are not reflecting the domestic economy.”

Comparisons with other stock exchanges also reveal a more disappointing picture. The FTSE 100 reached its record high back in June 2018 and has only recently got near that mark again. Over the same period, the US’s S&P 500 index has nearly doubled.

“Because of Brexit, no one wanted to invest in UK companies, so the FTSE has been depressed for a long time,” Coughlan says. “Now it’s having a bit of a rally because investors are seeing a recession heading into the US. Where can they find value? The FTSE 100 has been so beaten down that there are some bargains to be had there.”

Brexit: a continuing drag on trade

In addition to the Kwarteng mini-budget, another political choice continues to reverberate through the economy: the UK left the EU’s single market in January 2021 amid the Covid crisis.

Since then, its international trade activity has been slower to recover than that of the other G7 members. British import and export values are still below their pre-pandemic levels. By contrast, Italy, Germany and Japan have all increased their commerce with the rest of the world.

Brexit has already cost the UK 4% of its GDP and about £100bn a year in lost output, according to Bloomberg. 

“As a nation, we haven’t exactly worked out a clear post-Brexit direction – and that‘s started to affect our output,” Coughlan says. “The projections are pretty bleak.”