War in Ukraine stokes higher inflation

Across the last month, the news has been dominated by the human tragedy of the war in Ukraine. As the UK joins other international allies in sanctioning Russian firms, banks and individuals, this crisis will also have a ripple effect on the global economy. Russia is the world’s second-largest producer of oil and natural gas, while Ukraine and Russia together make up around a quarter of the world’s wheat exports. Both the conflict itself and the resulting sanctions have therefore stoked concerns about shortages in key commodity markets, pushing up prices at a time when inflation is already at its highest since 1992.

The Office for National Statistics (ONS) released data this week showing Consumer Price Index (CPI) inflation reaching a fresh 30-year high of 6.2% year-on-year, up from 5.5% in January. This once again beat consensus forecasts, and the cost of running a vehicle and energy bills were again the largest contributors to inflation. A further sharp acceleration in price pressures is likely to come in April when the Ofgem standard tariff for gas bills rises by over 50%. Yet the Office for Budget Responsibility (OBR) does not expect inflation to peak until late in 2022 when Ofgem raises the price cap again in October, based on wholesale gas prices between March and August. Those prices surged following Russia’s invasion of Ukraine, more than doubling across the first week of the war. While prices have mostly unwound that surge, gas remains more expensive on UK wholesale markets than in January and futures contracts suggest that those prices could rise across the rest of 2022.

Figure 1:

Data from the National Institute of Economic and Social Research (NIESR) suggest that London is facing the highest underlying inflation pressure of any region in the UK, with a CPI growth rate trimmed of volatile items of 6.1% year-on-year versus the national average of 5.1%. There are some mitigating factors for Londoners against key price pressures. Households in the capital use public transport much more than in any other region, partly insulating them from the impact of higher petrol prices. London properties tend to have the best record of energy efficiency, at least as measured by new energy performance certificates – partly because a larger share of London’s housing stock comes in the form of easier-to-heat flats. However, London also has the third-highest share of energy customers on pre-paid meters of any UK region, which may leave the worst-off households forced to self-ration their energy if they run low on income later in the month. Londoners tend to devote a similar share of their spending to food as in the rest of the UK, meaning they have no more insulation from rising grain prices than anywhere else in the country. National figures also demonstrate that low-income households tend to devote more of their spending to energy and food than high-income households, meaning this crisis is likely to further raise London’s already-sharp income inequality.

Bank of England caught between conflicting risks as it raises interest rates a third time

At its March meeting, the Bank of England’s Monetary Policy Committee (MPC) raised the interest rate from 0.5% to 0.75%. The three hikes between last December and this month represent the fastest monetary tightening in nearly 25 years. Yet despite choosing rapid action to combat rising inflation, which policymakers expect to reach nearly 10% by the end of the year, the MPC sounded a cautious note about the risks facing the wider economic recovery.

With commodity prices up and the squeeze on real income tightening, the “impact on real aggregate income is now likely to be materially larger than implied by the projections in the February Report, consistent with a weaker outlook for growth and employment”. The MPC also softened its wording around further policy tightening. In February, policymakers said that further rate hikes would be “likely”, but in March they offered a much more qualified suggestion: “the Committee judges that some further modest tightening in monetary policy may be appropriate in the coming months, but there are risks on both sides of that judgement” [emphasis added]. One member of the MPC (Jon Cunliffe) even voted to keep the policy rate at 0.5%.

London has seen the slowest recovery in unemployment from the pandemic out of any region of the UK, and real median payroll earnings in the capital started to trend down earlier than in the rest of the country. As a result, the growing concerns around incomes and employment coming from the Bank make for particularly sobering reading for Londoners. The pandemic wage recovery has tended to sharpen sectoral inequalities in the capital, with earnings growth since 2020 focused in already high-paid service sectors. Sectors like Hospitality and Construction have seen aggregate pay stagnate or even fall in real terms. Clearly, Londoners are increasingly concerned about the impact of inflation on their ability to spend, and in YouGov polling commissioned by the GLA in January, 45% of those surveyed said they would spend less on non-essentials, but as many as 21% already said they would buy less in food and essentials.

Chancellor delivers the Spring Statement

The Chancellor of the Exchequer, Rishi Sunak, delivered his Spring Statement on 23 March.  Some of the measures announced include:

• A 5p per litre reduction in fuel duty for petrol and diesel

• The annual National Insurance primary threshold will rise from £9,880 to £12,570 from July, and will be at the same level as the income tax threshold

• A doubling of the Household Support Fund for low income households to around £1 billion. It is estimated that London councils will receive around £68 million (or 16.1%) of the additional £421 million on offer to English councils.

• A reduction in VAT on energy saving materials such as solar panels, heating pumps and roof insulation

Government measures, announced in February and at the Spring Statement, broadly offset around half of the increase in household bills from the increase in the energy cap in April and October according to the OBR. Taking account of both energy and non-energy pressures, the policy measures announced since October offset a third of the overall fall in living standards that would otherwise have occurred in the coming 12 months. Consumption is likely to be given some support in the near term by a further drawdown of savings built up during the pandemic. Despite this support real household disposable incomes per person may fall by 2.2% in 2022-23, says the OBR, the largest fall in a single financial year since Office for National Statistics (ONS) records began in 1956-57.

While the Chancellor reduced taxes in the Spring Statement, taxes as a proportion of GDP are now expected to be higher over the years to 2026-27 than in October at the time of the Budget. The OBR estimates the tax take to reach over 36% of GDP in 2026-27. This is because the previously announced tax measures such as the freezing of personal allowances in income tax, and the introduction of the health and social care levy through National Insurance contributions will raise more money because of higher than predicted inflation.

Public sector net borrowing in 2022-23 in the latest OBR forecast is, though, £16.1 billion higher than in the October forecast at £99.1 billion (3.9% of GDP). The spike in inflation – both directly via debt interest and indirectly via policies put in place to help households cope with higher prices – outweighs the £30.1 billion upward revision to the forecast from higher than expected income and corporation tax. Debt interest spending jumps to a nominal record high of £83.0 billion, double that of the October forecast and its highest level as a share of revenue since 1997-98.

Across the forecast cumulative borrowing is lower, and so public sector net debt (including the Bank of England) peaks as a share of GDP in 2021-22, before falling to 83.1% of GDP by 2026-27. While debt has been revised down, the higher path for RPI inflation in the near term and for interest rates throughout the forecast have raised the cost of servicing the debt.

The severe effects of Russia’s invasion of Ukraine on the global economy

The Organisation for Economic Co-operation and Development (OECD) published a preliminary assessment of the global economic impact of Russia’s invasion of Ukraine. It is a severe economic shock of uncertain duration and magnitude, added to the shocks of the global financial crisis and the pandemic over the last 15 years. Prior to the invasion, global growth was projected to return to rates similar to those prevailing in the pre-pandemic period. Although Russia and Ukraine account for around 2% of world output at market prices, and a similar proportion of total global trade, they are large producers of key food items, energy and minerals – they account for about 30% of global exports of wheat, 20% for corn, mineral fertilisers and natural gas, and 11% for oil. The moves in commodity prices and financial markets seen since the outbreak of the war could, if sustained, reduce global GDP by over 1 percentage point in the first year, and push up global consumer price inflation by approximately 2½ percentage points. The impact on GDP in the Eurozone would be larger at 1.4 percentage points, due to its relatively greater dependency on Russian gas and oil, and for the US it would be around 0.9 percentage points.

An earlier publication by the National Institute of Economic and Social Research (NIESR), using the same economic model as the OECD, concluded that the UK economy would be 0.8 percentage points smaller. The OBR notes that compared to other European countries the UK economy is less energy intensive. This is partly due to the relatively large share of services in UK output. However, 76% of the UK’s gross energy consumption comes from gas and oil compared with a European average of 57%. So, as a net energy importer with a high dependence on gas and oil, higher global energy prices will still weigh heavily on the UK economy.

The OBR downgrades its UK growth forecast

As noted the OBR published its latest UK forecast on 23 March, alongside the Spring Statement. Output growth in 2021 is now expected to have been 7.5%, 1.0 percentage points higher than the OBR’s October 2021 forecast. However, the GDP forecast for the present year has reduced from 6.0% to 3.8%. This is because, “the large fall in real disposable income weighs on household consumption and real GDP”, and so is only partially attributable to the Russia-Ukraine conflict. Thereafter, GDP growth will pick up to 1.8% in 2023 as the effect of the fiscal expansion reaches its peak, before settling at an average of 1.9% between 2024 and 2026 (Figure 2). The level of real GDP from 2025 is unchanged from the October forecast as the assumption that the pandemic has led to economic scarring of 2% of GDP has been maintained.

Figure 2: UK GDP growth rates 2012-2026

Source: ONS, OBR

COVID-19 cases are rising again

In the week to 24 March there were 8,611 reported cases of COVID-19 in London. This compares with 3,832 cases three weeks earlier. These numbers remain relatively low compared with the most recent wave of the virus, but if they continue to rise at the same pace it will be of a similar magnitude to at least the wave in December 2020. There will be impacts for the economy from increased sickness absence and insufficient NHS capacity to process the backlog of treatments. The OBR notes that “further Omicron outbreaks and shutdowns in China present a risk to the outlook” of the global economy from supply chain bottlenecks.

The economy has learnt to adapt to the virus through changes in working practices, such as increased home working, and changes in spending patterns in a shift to goods from services. Increased immunity to the virus, the availability of vaccines and better treatments have also enabled society to respond with fewer restrictions. The latest UK monthly GDP figures indicate that the economy has suffered less impact with each wave of the virus despite the number of cases being markedly higher (Figure 3). The UK economy contracted by -0.2% in December, before rebounding by 0.8% in January, and in so doing exceeded the pre-pandemic level of output.

Figure 3:

Substantial downside risks remain – forecasts are assuming that there will not be a further adverse economic shock from COVID-19. A particular concern is the emergence of a vaccine resistant variant, and declining immunity over time to the vaccine. The OBR has modelled a scenario of a variant as contagious as Omicron, but that causes more severe illness and requires existing vaccines to be adapted, then manufactured and rolled out. Under certain assumptions GDP falls 3.5% in Q1 2023, then recovers from Q2 as infections fall and the vaccine is rolled out. A second wave of infections then causes GDP to fall by 1.8% in Q1 2024.

Mixed picture emerging for London

The S&P Global/CIPS Flash UK Composite PMI for March reports that, “Faster service sector growth boosts UK economy in March … and business optimism slumps to 17-month low”. The headline index registered 59.7 in March, down slightly from February’s eight-month high of 59.9. A stronger contribution from service sector activity (index at 61.0, up from 60.5) helped to offset weaker manufacturing sector growth (52.6 in March, down from 56.9). The service sector is less likely to be affected by energy price rises, to the benefit of London as 90% of economic activity is in services. One other concern is the exposure of London’s financial markets to Russian assets. It is thought this is relatively limited, as Russia reduced its overseas investments after the annexation of Crimea in 2014.

The LET supplement sets out the latest GLA Economics macroeconomic forecasts for London. These were published last month days after the invasion of Ukraine, with a preliminary view of its effects on London’s economy. In the central scenario these estimate London’s growth at 4.1% in 2022, and 3.1% in 2023. There is a broad range of uncertainty around these estimates with scenarios providing a range for growth of between 1.4% and 6.2% for 2022.

In contrast to a possible relatively positive outlook for growth, weekday (Monday – Thursday) daytime footfall in London has recovered the most slowly of the UK’s large cities.  The Centre for Cities reports that in February large cities, which are those that so far have struggled the most to get workers back, were approaching near full recovery at 90% of pre-pandemic weekday footfall. For London, footfall was at 57% of the pre-pandemic figure, although this is up from 44% in January, an unprecedented rise.

And, prior to the increase in National Insurance and energy prices in April, consumer confidence in London dipped to -13 in March from -3. This continues to remain ahead of UK sentiment which was -31 in March. More details are available in the LET indicators below.

GLA Economics will continue to monitor these issues over the coming months in our analysis and publications, which can be found on our publications page and on the London Datastore.