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London’s Economy Today editorial – Issue 247 – March 2023

Cost of living crisis not easing yet, despite Government measures

Inflation rose unexpectedly in February, with signs that some price pressures may take longer to ease. Consumer Price Index (CPI) inflation unexpectedly hit 10.4% year-on-year last month, up from 10.1% in January. The three main reasons were prices for restaurants and cafes, food and clothing. Alcohol served in restaurants, cafes and pubs saw prices rise particularly sharply, partly due to January discounts ending. But buying food at the shops offered no relief, with food and drink price inflation up to a 45-year high of 18.2%. While some of the hit came from short-term factors, like vegetable shortages, the figures are still a worrying reminder that price pressures remain widespread across the economy. Even if we strip out volatile energy and food prices, inflation is accelerating, which creates challenges for monetary policy. Core non-energy, non-food inflation rose to 6.2% year-on-year from 5.8% in January.

Figure 1:

While the headline inflation news was discouraging, this month’s Budget offered some relief for the cost of living. Most importantly, the Energy Price Guarantee (EPG) will continue to cap unit costs so that the average annual household bill will hold below £2,500. The original cap would have raised the threshold to £3,000 in April. But falling global wholesale prices for gas made hiking the threshold seem out of step with global economic conditions, and increasingly unnecessary as a measure to curb the cost of the scheme for the Exchequer. Between extending the EPG and freezing fuel duty, the Office for Budget Responsibility (OBR) estimated that Budget measures should cut 0.7 percentage points off inflation this year. Meanwhile, uprating benefits and the National Living Wage in line with inflation will offer help to those on low incomes.

Extending the EPG on its current terms should offer some relief to the poorest Londoners. Lower-income households typically devote more of their spending to energy bills, so the measure will give the most help to those on the lowest incomes. Using data on the different spending shares, the richest households in the UK may be experiencing inflation nearly 4 percentage points lower than the poorest households. Holding the EPG steady should roughly halve the gap by April, while raising it would have kept it nearly the same.

Other measures have a more mixed impact on low-income Londoners. Those in the capital are likely to get less relief from the freeze on fuel duty, as on average London households use cars less and public transport more. But Londoners may be more likely to benefit from banning higher costs for prepayment meters, as the capital has the lowest share of energy bills paid by direct debit in the UK. Households with prepayment meters are also disproportionately the poorest, and tend to be renters.

Inflation has some way to go before it returns to more normal levels. The OBR projected earlier this month that price rises would be around 3% by the end of this year, but the latest figures present upside risks to that forecast. What is more, even as inflation comes down, many of the poorest households will still be left struggling. Whether due to higher debt, poorer health or simply an ongoing squeeze as real incomes fall and costs stay high, the cost of living crisis will last some time.

Bank of England raises interest rates for the 11th time in a row

Continuing high inflation may have increased the Bank of England’s nervousness about ‘second-round effects’ where households and businesses come to expect higher inflation in future and bid up wages and prices. The minutes from the March 2023 meeting of the Bank’s Monetary Policy Committee (MPC) did note however that inflation “remains likely to fall sharply over the rest of the year”.

Still views of the members of the MPC are likely mixed on this issue. Thus Catherine Mann, thinks today’s high inflation will change the way households build their expectations in future, demanding stronger monetary tightening than current data suggest. However, other policymakers, such as Swati Dhingra, have previously pointed out that most of this ‘core’ inflation increase is still due to how import prices boost producer costs. And long-term inflation expectations did fall in the most recent Bank of England survey. Raising interest rates is also exposing weaknesses in some bank balance sheets, leading to financial sector jitters (see below).

Balancing these views, the Bank raised interest rates for the 11th time in a row this month, with rates rising to 4.25% from 4.0%. However, this was a smaller increase than the 0.5% hike in February, and many commentators feel that the current round of increases may be approaching an end.

Looking forward the Bank now expects the UK to avoid a technical recession. Policymakers continue to expect the economy to contract by 0.1% in Q1 2023. However, unlike in February, the Bank now thinks that GDP “will increase slightly in the second quarter, compared with the 0.4% decline” they had previously expected.

UK economic outlook improves, but stagnation still likely ahead

The OBR’s new set of forecasts accompanying the Budget showed an improvement in the outlook for the UK economy. Among the key headlines, perhaps the most eye-catching was the assertion, like the Bank’s later in the month, that the UK would ultimately avoid a recession. Forecasts for GDP, unemployment and inflation all improved, and the better outlook formed the foundation of spending increases and tax cuts. But there are some important caveats. The UK economy is still expected to stagnate this year, real incomes face their worst squeeze in decades and the share of interest spending and taxes in the economy is headed up.

In terms of the overall economy, the OBR’s forecast for GDP has picked up, but the UK economy is still expected to shrink by 0.2% across 2023 overall. Growth then picks up to 1.8% in 2024 and 2.5% in 2025. The combination of the changes across the next five years leaves GDP 0.5% higher in the longer term than at the November 2022 forecast. This is mainly down to improved assumptions around medium-term energy prices and higher inward migration. But the Government’s labour market policies, including more free childcare (see below), benefits changes and training schemes, are also expected to boost employment.

CPI inflation is set to fall to below 3% by the end of this year in their baseline and below 1% by the middle of next year. While unemployment is set to climb to a peak of around 4.4% in 2024, this is down from an expected peak of 4.9% in the previous forecast. That amounts to 170,000 fewer people unemployed between the new projections and the old.

Yet not all is well in the OBR’s forecast. Despite lower inflation and lower unemployment, the OBR still projects that we are in the middle of the worst two-year drop in real incomes since records began in the mid-1950s, at -5.7%.

The OBR’s projections are also quite optimistic compared to most other professional forecasts. This points to downside risks, and the OBR’s own fan chart envisions a one in five chance the UK economy could fail to return to growth in the entire forecast.

Figure 2:

Even if downside risks remain, the OBR’s profile points to potential upward revisions to our forecasts for London’s economy. Overall, we think that due to higher average incomes, lower energy bills and less pessimistic consumers, London is better placed to avoid a recession than the wider UK.

On the fiscal side, the OBR projects that public sector net borrowing (PSNB) will be 5.1% of GDP in the coming fiscal year (£131.6 billion). This is certainly a large deficit compared to pre-pandemic levels, but it is down from the estimated deficit of 6.1% of GDP in the fiscal year just ending. The OBR project that borrowing will ease steadily to a deficit of 1.7% of GDP by 2027-28, which is well below November’s expectation of 2.4% of GDP. Meanwhile debt as a share of GDP (excluding the Bank of England) is set to rise from just under 89% of GDP in 2022-23 to just under 95% of GDP by 2026-27. Debt then eases slightly to 94.6% of GDP in 2027-28.

While the deficit and debt profiles are both improved from the November forecasts, there are still clear signs that fiscal policy is in a tight spot. Debt interest spending as a share of GDP is increasing. By 2027, this measure is set to hold highs not sustained since the late 1980s. Meanwhile, the tax take required to keep the fiscal accounts trending in the right direction is large. Government revenues are projected to rise sharply to nearly 38% of GDP by 2027 – the highest levels since immediately after the Second World War. At the same time, this would still place the UK below many European peers.

Chancellor announces extension of free childcare

The OBR forecasts were published alongside the Budget which the Chancellor delivered on 15 March. Beyond the already discussed measures on the cost of living crisis other measures of interest to London included that the government will extend the scheme of offering 30 hours of free childcare to children from the age of 9 months, in addition to the current scheme which covers children aged 3-4 years old. The scheme will be extended gradually, with the full 30 hours offer only applying to all eligible working parents from September 2025. Parents on Universal Credit will also receive funding for childcare costs upfront rather than claiming it back in arrears and will also be able to receive a higher level of support.

Beyond this the other headline grabbing announcement was that the government will remove the threshold capping the “tax-free” pensions Lifetime Allowance from April 2023 and abolishing it from 2024. It has been observed that this change is likely to disproportionately benefit wealthier individuals. The Chancellor also announced that the pension contributions Annual Allowance will increase to £60,000 (from £40,000).

However, the Budget had no new devolution announcements specific to London, although it remains to be seen how the trailblazer deals for Greater Manchester and the West Midlands would affect London’s local government powers going forward. A refocused Investment Zones programme was also announced. This would concentrate on 12 “knowledge-intensive” growth clusters across the UK, although none of these are in London. There was however £8.4 million in regeneration funding for Waltham Forest. And Mayoral Combined Authorities and the Greater London Authority will share £161 million for regeneration projects.

Jitters around the stability of some banks

Global interest rates have been rising over the last year or so and this has led to challenges for some banks whose asset profiles had adapted to the low interest rate environment of the last decade or more. Thus, mid-March saw the US Federal Deposit Insurance Corporation take over Silicon Valley Bank (SVB), a bank that focused on the tech industry, after depositors withdrew $42bn in a single day. That was around a quarter of the Bank’s total deposits. This followed on from an unsuccessful share sale to raise additional capital for the bank. The collapse of SVB required the UK government and Bank of England to organise the fire sale of its UK subsidiary, SVB UK,  to HSBC for £1. There were worries that without this sale a number of UK tech firms would have faced serious trouble.

Following this collapse, attention focused on Credit Suisse, which had been facing challenges for a few years. Concerns were raised further when the Saudi National Bank, its largest shareholder, said in March that it would not provide any further funding. This led the bank to announce plans to borrow 50bn francs from the Swiss National Bank. However this was seen as insufficient to guarantee the stability of the bank and led to UBS announcing that it was taking over Credit Suisse.

Despite this banking uncertainty, in the minutes to the MPC meeting the Bank of England noted that its Financial Policy Committee (FPC) “judges that the UK banking system maintains robust capital and strong liquidity positions, and is well placed to continue supporting the economy in a wide range of economic scenarios, including in a period of higher interest rates. The FPC’s assessment is that the UK banking system remains resilient”. Nevertheless, bank shares remained jittery at the end of March.

Notwithstanding these issues the OECD has called for central banks to “stay the course” and to continue raising interest rates. In particular it observed that “interest rate increases are still needed in many economies, including the United States and the euro area. With core inflation receding slowly, policy rates are likely to remain high until well into 2024”.

OECD upgrades its world economic outlook

Looking at the global economy the OECD has improved their global growth forecast for this year and next. They now forecast global growth of 2.6% in 2023 and 2.9% in 2024 upgrades of 0.4 percentage points (pp) and 0.2pp respectively on their previous forecast. The Eurozone is forecast to grow by 0.8% (0.3pp higher than previously forecast) this year and 1.5% (0.1pp higher than previously) next year. While the US is expected to grow by 1.5% in 2023 (1.0pp higher than previously forecast) and 0.9% in 2024 (-0.1pp lower than previously). The forecast for UK growth was significantly lower than these forecasts this year with the economy expected to contract by 0.2% in 2023 (although this was 0.2pp higher than previously forecast) before growing by 0.9% in 2024 (0.7pp higher than previously).

Looking at global inflation they project it “to moderate gradually over 2023 and 2024 but to remain above central bank objectives until the latter half of 2024 in most countries. Headline inflation in the G20 economies is expected to decline to 4.5% in 2024 from 8.1% in 2022. Core inflation in the G20 advanced economies is projected to average 4.0% in 2023 and 2.5% in 2024”. Despite this expected improvement they note that inflationary risks are “tilted to the downside”.

Study argues London has impacted on poor UK productivity

A report from the Centre for Cities which was published this month has argued that a significant factor affecting the slow growth of UK productivity since the financial crisis has been the slow growth of productivity in London. It thus noted that between 2007 and 2019 productivity in “the Capital grew by just 0.2 per cent per year, accounting for 42 per cent of the overall slowdown nationally”. They argue this is a productivity performance that lags London’s global competitors. And they therefore observe that if London’s productivity had kept up with cities such “as New York, Paris, Stockholm and Brussels (all of which performed better than their respective national average) this would have added £54 billion to the UK economy in 2019 alone, which would have generated an extra £17 billion for the exchequer to spend”. In terms of what has happened to the capital’s productivity growth, they argue it’s hard to pinpoint but note that “rising costs for office space appear to have been eating up business budgets and crowding out investment associated with innovation”. While, “increasing housing prices and a restrictive migration policy also appear to have reduced London’s ability to compete for global talent”.

Still, despite the current slowdown of the economy the number of workforce jobs in London continued to rise in the latest data and this was at a faster pace than the rest of the UK. However, the employment rate (which declined) and inactivity rate (which increased) provide a more cautionary note in the latest labour market data for the capital.

GLA Economics will continue to monitor all these 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.