Uncertainty looms large over the United Kingdom, as a hung parliament in the recent general election has compounded Brexit-related concerns. Economic growth is likely to be impacted as consumers, already grappling with rising inflation, clamp down on spending.
In a world where growth is generally accelerating, and at a marginally faster-than-expected rate, activity in the United Kingdom is softening. The sharp devaluation of the sterling that occurred after the EU referendum in June 2016 has fed through to inflation and is now squeezing spending power (figure 1). In the first quarter of 2017, the economy grew by just 0.2 percent over the previous quarter, down from 0.7 percent in the final quarter of 2016.1 Having outperformed activity in the euro area in 2016, the United Kingdom is likely to be overtaken by it in 2017 as the euro area recovery strengthens.
Having outperformed activity in the euro area in 2016, the United Kingdom is likely to be overtaken by it in 2017 as the euro area recovery strengthens.
The consumer is, as in most rich economies, the engine of growth, and, in the United Kingdom’s case, accounts for about two-thirds of GDP. Consumer activity, which remained resilient in the face of the Brexit vote last year, has softened in recent months as rising inflation, which reached a four-year high of 2.9 percent in June, has eaten into spending power. With average earnings growing at around 2.0 percent, consumers are facing a decline in their spending power (figure 2). The ability of consumers to either borrow or save less to help bolster spending is constrained. After a period of rapid growth in consumer credit, driven particularly by car finance, banks are cutting back on credit lending. Meanwhile the savings ratio—the proportion of disposable income that is saved—has dropped to 1.7 percent, the lowest level in 55 years. While the inflation shock shows few signs of becoming embedded, and nominal wage growth remains weak, the prognosis is for inflation pressures to ease through next year. But the big picture is of a period of subdued, below-trend growth in consumer spending in 2017 and 2018.
Brexit has dominated UK politics since last June’s referendum. The result of the general election, which took place on June 8, has compounded Brexit-related uncertainties (figure 3). Rather than delivering a strong Conservative majority, as the government and most commentators had initially expected, the result was a hung parliament. To govern, the Conservative Party now relies on the votes of Northern Ireland’s 10 Democratic Unionist Party (DUP) MPs. The Conservative Party’s precarious situation, and the strong showing by the Labour Party under Jeremy Corbyn, has weakened the authority of the Prime Minister Theresa May. This, in turn, has fueled speculation about the possibility of either an early general election or a change in the leadership of the Conservative Party and the prime minister. And so, an election that was called by PM May to help strengthen her hand at home and in Brexit negotiations has ended up having the opposite effect.
Nonetheless, the most likely outcome for the United Kingdom is still that it will leave the European Union and that it will seek a relationship outside the single market and the European Union’s customs union. This is partly because the Conservatives, supported by the Eurosceptic DUP, hold a parliamentary majority. The government, if it can carry its own backbenchers, has the power to prevail. In addition, the formal position of the Labour Party, like the Conservatives, is that the United Kingdom should leave the European Union and its single market and end freedom of movement for EU citizens. The government will face stiff opposition and criticism in parliament and outside as it negotiates the United Kingdom’s exit from the European Union. Those opposed to Brexit seem to be coalescing around the idea of the United Kingdom staying in the European Union’s single market. However, this would mean accepted free movement of people, something which both Conservatives and Labour say they wish to end. Brexit is a process, not an event, and a process that has got more complex as a result of the general election. As the outcomes of the United Kingdom’s EU referendum last year and its general election this year demonstrate, making political predictions is a risky game. But my hunch remains that, despite the twists and turns, the United Kingdom is heading out of the European Union and its single market.
Brexit is a process, not an event, and a process that has got more complex as a result of the general election.
In the meantime, the question is what will happen to UK growth. The consumer is on a slowing path and, as a result, some slowdown in GDP growth is unavoidable. The extent of that slowdown should be mitigated by four factors. First, a 20.0 percent devaluation in sterling should boost Britain’s export and trade performance. Second, the global economy is recovering and this will help to boost UK activity. Third, the negative shock from higher inflation is likely to be transient, and inflation seems likely to ease next year, taking some of the pressure off the consumer. Fourth, Brexit-related uncertainties point to fiscal and monetary policy being more stimulative than would otherwise be the case. Thus despite the uncertainties, we would expected manufacturing, exports, and investment to pick up this year and look for below-trend growth of around 1.5 percent in 2017 and 2018.2