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London’s Economy Today – editorial – December 2022

Inflation eases, but cost of living still bites Londoners hard

The outlook for the cost of living may finally be stabilising, with tentative signs of a peak in inflation. But even as price rises decelerate, incomes are unlikely to catch up, leaving real living standards lower and consigning the economy to recession.

UK Consumer Price Index (CPI) inflation eased a little to 10.7% year on year in November, from 11.1% in October. The two largest contributions to the headline figure were once again energy and food, which made up 3.2 and 1.7 percentage points of annual inflation respectively. While vehicle fuel had also previously been a major driver, the third-largest contribution has now shifted to catering services, principally due to alcohol served in restaurants, cafes and pubs. Yet inflation remains broad-based (Figure 1). For example, overall services inflation, which tends to reflect overall domestic price pressures, held at 6.3% year on year.

Figure 1:

It is probably too soon to be sure that inflation has past its peak – the last year shows the range of global and domestic risk factors that could push up prices again. Food inflation continues to accelerate and housing costs may start to exert upward pressure as soaring asking rents pass into the overall housing stock. However, the deceleration is in line with Bank of England projections that headline inflation should peak around its current level.

Yet even if inflation does sustain a downward trend, this is likely to be quite gradual for some months and those in a difficult financial situation will still face a much higher cost of living. A recent report from the Joseph Rowntree Foundation (JRF) found that among low-income households across the UK, those in London are likely to be hit the hardest of any region. London has higher average incomes than other UK regions, and its housing stock tends to be relatively easier to heat. And yet despite this, the JRF’s survey data found that “London consistently had the highest proportion of low-income households experiencing hardship including going without essentials, experiencing food insecurity, in arrears with any bills or outgoings, and taking out new debt since the start of the year.”

Advanced economy central banks tighten policy despite easing inflation

The UK was not the only country to see inflation decelerate in November, with several key advanced economies seeing price rises ease. The US saw CPI inflation ease to 7.1% year-on-year, down from 7.7% in October and a peak of 9.1% in June. Eurozone inflation also pulled back, easing to 10.1% from October’s 10.6%.

But tentative signs of a peak in inflation across several major economies were still not enough to persuade central banks to stop hiking interest rates across the advanced economy world. The Federal Reserve, the European Central Bank (ECB) and the Bank of England all raised their policy interest rates by 0.5%. All three also signalled more rate hikes ahead. In the UK, this is the Bank’s ninth straight increase, putting the policy rate at a 14-year high of 3.5%.

Perhaps most surprising of all was the Bank of Japan’s (BoJ) decision to loosen its yield curve control policy – passively allowing long-term interest rates to rise higher. The BoJ is the last major holdout against tightening monetary policy, after years of chronically low inflation and minimal wage growth in Japan. While inflation is now above the BoJ’s 2% target, at 3.7% it is still well below the pace in other advanced economies. And policymakers say they will not begin to actively tighten until they see evidence of accelerating wage growth.

Global inflation pressures may be peaking, but China reopening creates uncertainty

Slowing inflation in the UK, along with the US and Eurozone, reflects a growing range of signs that key global price pressures are peaking. The New York Fed’s Global Supply Chain Pressure Index eased sharply across this summer and autumn and is now at some of its lowest levels in the last two years. This should bring relief to parts of the economy with highly globalised supply chains, such as the car market. Second-hand cars, which had been an early inflation driver, are now seeing prices in the UK falling 5.8% year-on-year.

Global oil prices have also steadily declined over recent weeks, with Brent crude hovering at around $80 per barrel. These are some of the lowest levels for global oil costs in a year, which showed up in decelerating vehicle fuel inflation in the US, Eurozone and UK. Even natural gas prices have come off a recent bump, though these remain very elevated compared to levels from before Russia’s invasion of Ukraine.

More broadly, the S&P Global PMI Commodity Price & Supply Indicators showed commodity prices now rising at around half their normal pace, the joint lowest since June 2020, while supply shortages were at their least severe since October 2020.

But a wide range of uncertainties remain, including the future path of China’s economy. After almost two years of very tight restrictions in response to COVID-19 outbreaks, China has now reversed course on its ‘Zero COVID’ policy. However, natural and vaccine immunity to the disease remain low in the world’s most populous country, meaning looser restrictions are spurring massive virus outbreaks. Official data shows cases are still low, but this is likely due to a collapse in testing. With reportedly low rates of vaccination among the elderly population and a growing strain on health services, the rapid reversal of the Zero COVID policy could carry a high human cost. There is even the risk that such a high level of circulation in a susceptible population could lead to a new variant of concern of COVID-19.

In economic terms, the impact could also be significant. While a looser policy towards COVID was expected to prompt improved growth in China and fewer supply chain disruptions due to lockdowns, this conclusion is now in doubt. Anecdotal evidence suggests that the outbreak is keeping workers at home, which may prompt fresh disruptions to key production and distribution sites. And even if the current outbreak proves short-lived, stronger Chinese demand could prompt higher prices in commodities. In either case, developments in China could yet prompt continued global inflationary pressure.

Tourism numbers in London are recovering

Looking closer to home GLA Economics has published its latest tourism forecasts. International tourism has recovered more rapidly than expected, and visitor nights in 2022 Q2 were around 90% of their level in 2019 Q2 according to the ONS. On the online flight booking search service Google Flights, London was the top trending world city by Americans in 2022. There is expected to be steady growth, and international visitor nights are estimated to exceed their pre-pandemic peak by the middle of the decade, (Figure 2). Over a longer time frame the number of nights will grow more slowly constrained by airport capacity.

Figure 2:

London forecast for recession, but a shallower drop than the wider UK

Alongside the detailed London’s Economic Outlook report, GLA Economics published its latest macroeconomic scenarios-based forecast for London on 14 December. Our central scenario now anticipates a recession in London’s output, starting in the second half of this year and contracting through to the middle of 2023. While the pandemic recovery in 2021 was rapid, high inflation is increasingly dragging on real incomes and aggregate demand in the capital.

This Recession and gradual recovery scenario is our new baseline, and is a significant downgrade on our previous forecast. Yet it is still better than projections for the wider UK economy. The Office for Budget Responsibility sees the UK economy contracting by just over 2% peak to trough, and the Bank of England anticipates a downturn of nearly 3% in UK GDP. GLA Economics expects London’s output to fall 1.3% from peak to trough in the coming recession. This is because on average Londoners have higher incomes, devote a smaller share of their spending to energy and are less pessimistic about the economy in surveys.

The central scenario is accompanied by two others, a plausible upside (Mild downturn, rapid recovery) and a plausible downside (Deep recession, slow recovery). A range of risks could push the forecast in either direction. Perhaps the key question for scenario planning is how households absorb the shock of rapidly rising prices. The ONS has revised up its estimate of the stock of excess savings built up during the pandemic. Who has these savings and whether they will draw on them in the year ahead is pivotal in determining the size of the coming recession. Other key risks include how persistent inflation proves, whether the energy market settles, how businesses respond and the path of fiscal and monetary policy.

Despite the downgrade to our baseline, risks are skewed to the downside. All three of our forecast scenarios anticipate a recession in output in the coming quarters (Figure 3). The Deep recession, slow recovery scenario involves output falling back below pre-pandemic levels by the end of this year, and not returning above them by the end of 2024. In this scenario, the disproportionate impact of the cost of living crisis on low-income Londoners becomes probably the defining feature of the outlook – these are also the households with the highest propensity to spend their income. The recession in this scenario is slightly worse than OBR projections for the UK average, with London’s economy declining 2.5% peak to trough. This scenario also sees output failing to catch up with its pre-pandemic trend growth path, even in the long run.

On the other hand, our Mild downturn, rapid recovery scenario sees the London economy weather the shock of high inflation much better. In this scenario, the savings buffer accrued by high-income households allows them to keep spending, supporting the wider economy. The peak to trough decline in output is just 0.3%, with activity never coming close to falling back to pre-pandemic levels. Output flattens out sooner and the recovery is complete by mid-to-late-2023, compared to mid-2024 in the baseline.

Figure 3:

As overall output and activity goes into reverse, this will also have consequences for London’s labour market. We expect a jobs recession to accompany the GDP recession, though employment is likely to see a shallower fall (Figure 4). After jobs reached pre-pandemic levels in Q2 2022, only the downside scenario sees employment falling back below those levels. And even in this downside, recovery takes place by late 2024.

We expect employment to be less volatile than output. Starting from a tight jobs market means labour demand goes into the recession in a position of strength, and a relatively shallow output recession means firms are likely to keep workers to avoid re-hiring costs. Our baseline forecast anticipates a peak-to-trough decline of 1.0% for employment, while our Mild downturn, rapid recovery scenario, sees a decline of 0.3%. And even in our Deep recession, slow recovery scenario, jobs are expected to see a relatively shallow 1.5% decline.

Figure 4:

It is important to note that these profiles do not capture the full range of uncertainty about the future, which is likely to lie outside the range of the scenarios. If the Bank of England’s more pessimistic projections for the UK economy are borne out, this could imply a profile for London below our current downside scenario. And in the long term, uncertainty rises further, with trends in labour market inactivity and inward migration hard to pin down.

Even in our baseline Recession and gradual recovery scenario, there is a wide range of outcomes for different industries in London’s economy. The sectors facing the deepest declines in the coming year are likely to be those most exposed to consumer spending or the housing market.

London enters the new year facing challenges

As noted above London’s economy is experiencing a downturn and a number of economic indicators have started showing this. As shown in the indicators section of this newsletter the business activity and new business PMIs for London have been showing contractions since October although the employment PMI continues to show growth.

Looking at official ONS data for London’s labour market gives an insight into the current state of the economy and provides evidence of some continuing strength but perhaps also some indication of the slowdown. So, London’s unemployment rate was estimated at 4.5% in the three months to October 2022. This was up 0.2 percentage points (pp) on the quarter but was still down 0.9pp from a year earlier. The employment rate in London showed more strength and was estimated at 75.9% for the same three months. This was up 1.0pp on the previous quarter and also up 0.4pp on the same period in the previous year.

Despite the slowdown London remains an attractive business location as shown by Microsoft agreeing to take a £1.5 billion (or 4%) stake in the London Stock Exchange Group (LSEG). This is part of a 10-year strategic partnership. David Schwimmer, LSEG chief executive, described the agreement as “a significant strategic partnership where we’re building products together and accessing markets together”.

Meanwhile, the Government has announced a series of reviews and reforms to financial services regulation. These will include a review of the rules separating retail banking from investment operations.

GLA Economics will continue to monitor all these trends and other aspects of London’s economy over the coming months in our analysis and publications, which can be found on our publications page and on the London Datastore.