Shortly after the UK voted to leave the European Union, the overall narrative about the UK economy was one of doom and gloom. Economists predicted a sharp and imminent slowdown in activity, with the most pessimistic seeing the UK economy falling into recession. As uncertainty reached a level higher than ever before, households would stop spending and businesses would stop investing – a sort of Apocalypse now!
But as the UK economy showed impressive resilience over the second half of 2016, a better outlook started to emerge. In its February Inflation Report, the Bank of England has significantly upgraded its forecasts for 2017 to 2% up from 1.4% in its November Inflation Report. Today the European Commission’s Winter Forecasts showed a similar upward move, with forecasts for the UK improving by 0.5 percentage points to 1.5% for 2017.
So what’s behind the improved outlook?
1. A stronger resilience in the labour market
Back in July, most economists feared a sudden deterioration of labour market conditions. The unemployment rate was expected to drift up quickly, squeezing households’ disposable income.
The labour market resilience in the second half of 2016 was the first surprise on the economic front. The unemployment rate continued to fall, reaching a 10-year low of 4.8% in December. This led most economists to revise their judgement on the labour market.
2. Inflation is drifting up, but at a slower pace and not for the same reasons
The plunge in the sterling exchange rate in the aftermath of the EU referendum result prompted economists to significantly upgrade the outlook for inflation. As a consequence of the sterling depreciation, consumer price inflation was expected to accelerate quickly, overshooting the Bank’s target as soon as early 2017.
Consumer price inflation started to accelerate indeed, but this trend reflected unwinding base effects from the dive in oil prices a year ago followed by the recovery in oil prices from November 2016. The sterling depreciation did affect producer prices, with input costs surging to multi-year highs, but the pass-through into higher consumer prices is taking more time to materialise.
3. Wages – the big question
The outlook for growth in average earnings is a central part of the different forecasters’ scenarios – and is subject to debate. In its latest Inflation report, the Bank of England expects average weekly earnings to grow by 3% in 2017 – slightly revised upward from November. The Bank notes that the persistent slack on the labour market should limit wage growth in the year ahead. The European Commission expects a slower expansion in average earnings, which it thinks are set to increase by 2.4% in 2017.
Risks to wage growth are skewed to the downside. The slower-than-expected uptick in CPI inflation, uncertainty and the persistent slack on the labour market should all weigh on firms’ intentions to offer higher pay levels. We will be releasing our pay bulletin later this week, and that will provide an indication of pay settlement levels across manufacturing.
4. Uncertainty around the impact of uncertainty
Economists are split on how to account for the impact of uncertainty. Will businesses freeze investment plans? Will consumers stop spending? Recent trends showed that private consumption and investment – although to a lesser extent – were holding up post-referendum. For the latter, our Exec Survey published in January showed that manufacturers are still pressing ahead with investment and innovation despite uncertain economic conditions. In a recent speech, Sir Jon Cunliffe, MPC member, noted that uncertainty was adding to the weakness in business investment - but other financial and non-financial constraints are likely to be playing an equally important role.
The question is: how long will this apparent resilience last?
5. A better global outlook
Finally, the world economy is in a far better shape now. Economic activity ended 2016 on a strong note in developed economies, with GDP growth accelerating in the final quarter in the US and the Eurozone. Emerging markets also show brightening economic conditions, with China expanding at a robust pace and Russia recovering from a prolonged recession. This, with the persistent weak pound, is providing a boost to UK exports.
Tell us your view
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The UK economy is holding up so far and the outlook for the year ahead is significantly better from the gloomy picture most economists had painted in the aftermath of the EU referendum. This is all good news. But more is yet to be done to improve the long term competitiveness of the UK economy. The on-going consultation on Industrial Strategy is an opportunity - Visit EEF's Industrial Strategy Hub to get an overview of our campaign on behalf of manufacturing.