UK data has painted a contradictory picture over the past month. The economy grew faster than expected in the second quarter, consumer confidence is up and public borrowing was significantly lower than feared on the back of strong tax receipts.
But purchasing managers’ indices, or PMIs, which measure real time economic activity, dropped to their lowest level since January 2021, sales were weak and unemployment has started to climb.
The diverging trends have caused confusion in the markets, leading to fluctuating bond prices and interest rate predictions. The two-year government bond yield and December rate expectations quickly increased after record-high wage growth was reported earlier in the month, only to fall again following underwhelming sentiment indicators.
So what’s going on?
Inflation and wage growth
Economists say the rollercoaster of conflicting economic news is largely owing to stagflation, which indicates a period of high inflation coupled with a stagnating economy. When this happens, measures that are not adjusted for price growth can rise quickly.
The trend is clearly visible in UK wages, which rose at the fastest pace on record in the three months to June, and high job-to-job moves — reflecting workers trying to limit the hit to their finances coming from high inflation and rising rates.
While inflation is easing, prices still grew by an annual rate of 6.8 per cent in July, more than three times the Bank of England’s target of 2 per cent.
In cash terms, total wages are up 21 per cent from the three months to February 2020, but when adjusted for inflation they are largely unchanged. This strong wage growth likely helped the 5-point increase in UK consumer confidence in August.
“During a period of stagflation you would expect indicators in nominal/cash terms — such as wages and tax revenues — to be rising by more than real indicators, such as the PMIs, real gross domestic product or real gross domestic product growth,” said Paul Dales chief UK economist at Capital Economics.
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Public finances
The fast price and wage growth rates have been good news for the country’s public finances. In the first four months of the current fiscal year, borrowing came in at about 17 per cent less than forecast by the Office for Budget Responsibility, the UK fiscal watchdog.
The government’s finances “have benefited” from high inflation, said Victoria Scholar, head of investment at Interactive Investor, an online investment service.
“Inflation tends to provide a boost to government tax receipts because it pushes earners into higher tax brackets, particularly with wage growth currently at a record high,” Scholar explained.
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The economy
The combination of high inflation — which boosts VAT and corporate tax — and high wage growth — which boosts income, national insurance and flat tax allowances — “tells us little about the state of the real economy,” said Thomas Pugh, economist at consulting firm RSM UK.
In fact, the UK economy is smaller than it was before the pandemic in the final three months of 2019, having largely stagnated since the end of 2021. This is despite lower wholesale energy prices and extensive government support to businesses and households, which helped avoid an economic contraction over the winter and the spring.
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“What we are seeing is an economy that is suffering from a big terms-of-trade shock”, said James Smith, research director at the Resolution Foundation think-tank, referring to the period when British imports became much more expensive than exports following Russia’s invasion of Ukraine and the imposition of increased trade barriers with the EU after Brexit.
According to Smith this “shock” resulted in prices and wages increasing rapidly and interest rates rising.
“The combination of all that is starting to get some traction on the real economy,” he said.
The outlook
Rising interest rates will test the UK’s economic resilience in the coming months, economists warn, with the first pressures already visible in the unemployment rate, which rose to 4.2 per cent in the three months from June, the highest in nearly two years.
Mortgage approvals also fell by nearly 10 per cent between June and July. Last month retail sales disappointed too, falling 1.2 per cent compared with the previous month. However, this may have been driven more by unusually wet weather than by underlying weaknesses in consumer demand.
The real worrying sign came from tumbling PMIs, which indicated a downturn in activity in both the services and manufacturing sectors in August.
Rather than conflicting with more positive official economic statistics, which are published with a longer time lag, PMIs are closer to real time indicators, say analysts.
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Economists say the most recent PMIs suggest interest rates are starting to weigh on economic activity. At its next monetary policy meeting in September, the BoE is expected to increase interest rates for the 15th consecutive time since December 2021. The central bank’s benchmark rate now stands at 5.25 per cent, a 15-year high.
This could put a further brake on economic activity, eventually reversing the positive news in the latest wage and public finance data.
“If the PMIs mean that the economy is heading for a mild recession, as we expect, then in time that would lead to less robust tax revenues and slower wage growth,” said Dales.
Source: Economy - ft.com
