Economic upturn on track – inflation to pick up next year

• The economic upturn in the UK is on track and we still expect the UK to grow by 2.6% this year and 2.5% next year. We expect growth to be driven mainly by domestic demand and in particular by private consumption.
  

• As the growth outlook remains solid, investor focus has moved to inflation in the wake of lower oil prices and stronger sterling. We expect CPI inflation to stay very low for the rest of the year and then to pick up in January although the lower oil prices, energy bill price cuts and a strong sterling imply that the pickup will be smaller than we previously expected.
  

• We think that the Bank of England wants to see CPI inflation stabilise/move higher before raising rates and thus we expect BoE to hike in Q1 2016, probably in February.

Growth to be driven by domestic demand

The economic upturn in the UK is on track and we expect the UK to expand slightly above trend in the coming quarters. We expect growth to be driven mainly by domestic demand and in particular by private consumption as the outlook for private consumption remains solid. Private consumption is supported by a combination of higher employment, positive real wage growth for the first time since 2009 and high consumer confidence.

While we expect private consumption to grow, we expect zero growth in government consumption in the coming quarters. Government consumption has surprised on the upside so far this year and grew by 0.9% q/q in both Q1 and Q2. The government’s fiscal consolidation plans mean that we see limited room for growth in government consumption going forward. In our view, the risk is that the speed of adjustment will be faster than currently anticipated by the market and thus will pull down growth. That said, it seems appropriate to tighten fiscal policy as the UK economy is expanding at a solid pace even without expansionary fiscal policy. Also, monetary policy is still extremely accommodative and will probably only be tightened very gradually.

We expect investments to continue to grow at a solid pace as more private firms are close to their capacity limits and labour has become increasingly expensive. Downside risks to our forecast are the fiscal consolidation plans and the upcoming EU in/out referendum. The fiscal consolidation plans may weigh on total investments through lower government investments. The upcoming EU in/out referendum raises the issue that firms may be reluctant to invest: the possibility of a vote to ‘leave the EU’ means that the future economic environment for British firms is uncertain.

The outlook for exports remains subdued due to a combination of slow growth in the rest of Europe (the UK’s biggest export partner) and the strong sterling. Net exports are expected to pull GDP growth down by 0.3pp in 2016.

Inventories have declined in recent quarters and we expect them to increase slightly in the coming quarters thereby contributing to growth.

Unemployment rate likely to fall further

The improvement in the labour market eased off in Q2. Employment declined for the first time since Q1 2013 and the unemployment rate in Q2 rose to 5.6% from 5.5% in Q1. We do not expect this to be the beginning of a new trend and we expect employment to pick up in the coming quarters as the growth outlook still remains solid although the pace will probably be slower than in previous quarters. As we do not expect the labour force to expand as rapidly, growth in employment should lower the number of unemployed persons and thus the unemployment rate. We expect the unemployment rate to decline to 5.2% in Q4 2016 which is below the BoE’s estimated mediumterm equilibrium rate of around 5.5%. Wage growth has already picked up this year and is now at the highest level since the financial crisis. We expect wage growth to pick up further as unemployment crawls below the NAIRU. This view is supported by our wage growth indicator which still indicates increasing wage growth.

BoE uncomfortable with near-term inflation outlook

In general, we see five pre-conditions for the BoE to increase interest rates as illustrated in the table to the right: (1) a return to ‘normal’ unemployment at or below the BoE’s NAIRU estimate, (2) an increase in wages at an annual pace of above 2%, (3) a growth outlook above the trend of 0.5% q/q, (4) a bottoming out of inflation and, finally, (5) no stress in financial markets. While the case for a rate hike is still building with unemployment back to ‘normal’, increasing wage growth and a solid growth outlook, we believe that the BoE still wants to see CPI inflation stabilise/move higher before hiking. As our main scenario is that China does not face a sharp slowdown as it did in 2008 we expect financial markets to calm down eventually such that the fifth pre-condition is also fulfilled.

The lower oil price and strong sterling weigh on the near-term inflation outlook. Our main scenario is that CPI inflation will stay at around 0% during the autumn but one cannot rule out that inflation could turn negative again during this period. The falls in energy and food prices should begin to drop out of CPI inflation around year end but the recent decline in oil prices, the announced energy bill price cuts by energy suppliers and the strong sterling imply that the pickup in inflation around the turn of the year will likely be smaller than the market previously thought. We expect CPI inflation to pick up to 0.9% in January. CPI inflation to increase further during 2016 and eventually to reach 1.7% at the end of 2016. Also core inflation is subdued but we expect it to pick up in line with headline inflation. We expect core inflation to reach 1.6% at the end of 2016.

Most MPC members are unlikely to feel comfortable with the near-term inflation outlook but the pickup in January should reduce concerns. In other words, the BoE can tick off the last but one of our boxes around the turn of the year and thus our main scenario is that BoE will hike in Q1 16, probably in February. We expect the BoE to increase the interest rate at a relatively modest pace of around 75bp annually in the coming years, taking the Bank Rate to 1.25% by the end of 2016.