UK economy: After a busy week, the foundations look solid

UK economy watchers had another busy week with a raft of major data releases alongside another Bank of England interest rate decision.

Here’s a reminder of this week’s major economic headlines:

• Inflation remained at 2.2 per cent in August, but services inflation rose back up to 5.6 per cent. The increase in services inflation was expected, but it confirmed that sticky price pressures persist.
• The Bank of England voted to hold interest rates at five per cent by a majority of eight to one after last month’s cut. Officials signalled that rates would only be reduced gradually in the months ahead.
• There were divergent signals on the consumer outlook. GfK’s consumer confidence index plummeted but retail sales were much stronger than economists had expected. 
• More negative news on the public finances, with monthly borrowing figures passing expectations while debt climbed to 100 per cent of GDP.

So, what do these figures suggest about the state of play in the UK economy?

Start with monetary policy. August’s inflation figures reinforced the Bank’s view that inflationary pressures are dissipating, but only slowly.

Although Bank officials insist they are looking at the economy in the round, services inflation remains one of the most important metrics as policymakers consider their next move.

August’s increase to 5.6 per cent was driven largely by erratic movements, such as the 22 per cent monthly increase in airfares, but that does not change the fact that services prices remain a concern.

Ruth Gregory, deputy chief UK economist at Capital Economics said: “There’s no denying that services inflation is still too high for the Bank of England’s liking”.

Indeed, Governor Andrew Bailey insisted that the Bank needed to be careful “not to cut too fast or by too much” given fears about sticky inflation.

This helps to explain why the Bank opted to leave rates at five per cent. But, remember the increase in services inflation was very much expected. In fact, it is running below the Bank’s August round of forecasts.

Alongside easing wage growth, services inflation is expected to fall later in the year, which should pave the way for at least one more rate cut this year, likely in November.

Before the decision, markets had been close to pricing in a second cut in December. That always looked a bit optimistic. The Bank’s cautious rhetoric suggests it is very unlikely.

And what about the health of the consumer?

GfK’s consumer confidence reading for September sparked some alarm. The index – which measures how people view their personal finances as well as the state of the broader economy – fell precipitously, wiping out all the gains made so far this year.

Neil Bellamy, consumer insights director at GfK, put the blame on Labour’s gloomy rhetoric ahead of the Budget. Consumers are “nervously awaiting” October’s set-piece, he said.

Chancellor Rachel Reeves has repeatedly warned that the government faces “difficult decisions”, a thinly veiled reference to looming tax hikes.

Goldman Sachs expect taxes will have to go up by “at least” £15-20bn to help balance the books.

This morning’s public finances figures only strengthened the view that taxes will have to go up in the Budget. Borrowing in the financial year to date has come in £6.2bn higher than the OBR’s March expectations.

“Considering the more intense pressures on the public purse than was anticipated, Chancellor Reeves’s job on 30 October has become even more challenging,” Ellie Henderson, UK economist at Investec said.

All very gloomy. But what about those retail sales figures?

Sales volumes rose 1.0 per cent in August, a larger increase than even the most optimistic forecaster. July’s figures were also revised up to a 0.7 per cent increase from 0.5 per cent previously.

The release suggested a large part of the increase stemmed from a combination of discounting and warmer weather, which may not last. Nevertheless, it does suggest that consumers are fundamentally in a fairly healthy position.

This is not too much of a surprise. Real wages have been rising fairly rapidly as inflation has receded while interest rates are heading lower. Many economists expect consumer confidence to rebound as a result.

Rob Wood, chief UK economist at Pantheon Macroeconomics, thought “economic fundamentals (would) drive improving sentiment” while Matt Swannell, chief economic advisor at the EY Item Club, thought the drop would prove a “temporary setback”.

With inflation low and further rate cuts to come the UK economy remains on relatively solid foundations.