Interest rates rise as do fears of stagflation

This month the Bank of England (BoE) has raised interest rates to 1.25% from 1%, to counter inflationary pressures. This is its fifth increase from successive meetings of the Monetary Policy Committee. While the latest Consumer Price Inflation (CPI) figures provided evidence of a slowdown in the growth rate of inflation, rising by 9.1% in the 12 months to May after an increase of 9.0% in April, the Bank reckons that inflation may reach 11% before the end of year. This is in part because there will be a further significant increase in household energy prices in October.

Low growth combined with high inflation increases the risk of stagflation. Growth in the UK economy remains weak, in part, because of the cost-of-living crisis discussed below. The Office for National Statistics (ONS) estimates that the UK economy shrank by 0.3% in April, after a fall of 0.1% in March. The fall in output in April was widely based: services fell by 0.3%; Manufacturing by 1.0%; and Construction by 0.4%. More positively, the loss of output from the significant reduction in NHS Test-and-Trace activity in April by itself more than accounts for the fall in GDP, and GDP grew by 0.2% over the three months to April 2022. Still, at least indicators of business confidence at the London level, reported in the LET Indicators section below, remain healthy.

The Organization for Economic Cooperation and Development (OECD) in its latest forecast sees the prospects for the UK next year as poor with it predicted to see the second worst growth across the G20 after Russia. Laurence Boone, chief economist at the OECD, said the UK was unique in simultaneously grappling with high inflation, rising interest rates and increasing taxes. “Inflation is high compared with other OECD countries in the G20 … that’s one thing. The other thing is there is fast monetary tightening, which is obviously responding to [the inflation], and there is fiscal consolidation, which is the highest in the G7.” The OECD UK forecast for 2022 is growth of 3.6%, but this would fall to zero next year as households are increasingly squeezed.

The comparative weakness of the UK economy has been reflected in the pound depreciating against other major currencies. Since January the pound has fallen by more than 10% against the dollar, although the fall against the euro has been less than 5% (Figure 1). Currency depreciation reflects, in part, a lesser willingness on the part of overseas lenders to purchase government debt – the UK Government is relatively more reliant on this source of finance than other countries because of the low UK savings rate. Interest rate increases can offset this tendency with the consequence of higher debt servicing costs – UK Government debt interest costs rose to £7.6 billion in May, up 70% from last year.

Figure 1:

Inflationary pressures are global, and slowing global economic growth

The major central banks, like the BoE, are raising interest rates to tackle inflationary pressures from supply chain shortages and increases in food and energy prices. The US Federal Reserve raised its benchmark policy rate by 0.75 percentage points to a target range of 1.50 – 1.75% and said that another adjustment of that size was possible at its next meeting. The European Central Bank (ECB) signalled that it was likely to raise interest rates by half a percentage point in September in addition to a planned quarter-point rise in July. This would lift interest rates in the Eurozone above zero for the first time in a decade.

The OECD in its latest Economic Outlook notes that prior to the war in Ukraine the world economy was on track for a strong, albeit uneven, recovery from COVID-19. The conflict and supply-chain disruptions exacerbated by shutdowns in China due to the zero-COVID policy are dealing a serious blow to the recovery. Global GDP growth is now projected to slow sharply this year to around 3% and remain at a similar pace in 2023. This is well below the pace of recovery projected last December.

The World Bank also published its Global Economic Prospects in June. It estimates that the fallout from the war in Ukraine will intensify the effects of the pandemic leaving 75 million more people in extreme poverty than expected in 2019. This will raise the risk of a debt crisis in low and middle-income countries. Global conditions today are similar to the 1970s when interest rate rises sparked a global recession and a string of debt crises in developing economies. The commodity price shock has been less severe so far this time, although middle-income economies are particularly exposed with foreign debt rising by $423 billion to more than $8.5 trillion in 2020. Similar to the OECD, under its base case scenario, the World Bank expects global growth to fall from 5.7% last year to 2.9% this year and 3.0% in 2023.

Expectations for London’s economy also diminish

At the end of May the ONS released its first annual estimates of GVA growth for London’s economy in 2020. London’s output fell by 9.2% in 2020, although by 2021 Q3 it was close to reaching pre-pandemic levels (2019 Q4). This updated the previous ONS estimates from its quarterly regional GDP publication and revises substantially the picture of London’s progress through the pandemic. These estimates suggest that London’s economy has not weathered the pandemic better than the rest of the UK as previously thought. Instead, it appears that progress has been in line with the rest of the economy (Figure 2). ONS also produces nowcast modelled estimates of quarterly GDP, which GLA Economics does not use. While more timely, the estimates are not based on data for the economy, which is reason to believe they are not as robust. They are showing that London has performed better through the pandemic, a conclusion which has received some publicity, and may well be misleading.

Figure 2:

This month GLA Economics has published its latest forecasts for London’s economy – the LET supplement provides a summary of the main findings. As with the UK economy the forecast of prospects for London’s economy has been reduced. Under the central, gradual return to economic growth, scenario, London’s real GVA (output) is expected to grow by 4.5% this year, 1.6% in 2023, and 2.3% in 2024. Jobs will take longer to feel the impact of the recovery, and are not expected to reach pre-pandemic levels until 2023. After ticking up 0.3% last year, growth of 2.2% is expected this year, 1.1% in 2023, and 1.2% in 2024.

The cost-of-living crisis deepens for Londoners

As a sign of a deepening crisis UK retail sales volumes fell by 0.5% in May, although they rose by 0.4% in April, and were 2.6% above their pre-pandemic February 2020 levels according to the ONS. Further, the effect of a currency depreciation is that it makes everyone worse off because the price of imports is higher. More positively consumer confidence was little changed, if slightly worse, in June for both London and the UK despite remaining at a low level by historic standards – the LET indicators below provide more information.

The GLA employs YouGov to help track the impact of the cost-of-living crisis. Over the period January – May 2022 a steady proportion of around 35% of Londoners have been coping okay. The proportion which is comfortable has fallen from 23% to 14%, with those ‘just about managing’ rising from 23% to 28%, and people struggling financially rising from 12% to 15% (Figure 3). The groups more likely to say there are struggling financially are from lower social classes (C2DE), Asian Londoners, those with an income of less than £20,000, renters (and in particular social renters), and deaf and disabled Londoners.

Figure 3

The degree to which households cope with the crisis will depend in part on the degree to which wages keep up with inflation. UK data from the ONS up to the quarter to April indicates that growth in employee’s average total pay (including bonuses) was 6.8%, slightly higher than inflation, while excluding bonuses it was 4.2%, a fall of 2.2% after inflation. There were, though, some large sectoral differences. Average total pay growth for the private sector was 8.0%, while for the public sector it was 1.5%.

London made the smallest call on public finances during the pandemic

Since 2009-10 London had been a net contributor to public finances. The latest figures from the ONS show that London moved into fiscal deficit in 2020-21 due to the pandemic. Its deficit was £800 per person compared with a surplus of £4,500 per person in 2019-20. This was the largest change across the countries and regions of the UK, yet London still made the smallest call on public finances (Figure 4). In aggregate, its total fiscal deficit was £7.2 billion in 2020-21 compared with a surplus of £40.5 billion in 2019-20.

Figure 4:

All countries and regions of the UK saw a large increase in public expenditure in 2020-21 – identifiable COVID-19 support scheme spending was the main contributor to the increase in expenditure. As reported previously London was the region which made the greatest use proportionately of the furlough scheme, had the largest per head increase in Universal Credit claimants, and has a disproportionate share of businesses. Health was the second biggest contributor to expenditure, and London also received significant additional support for its transport networks. All countries and regions saw, as well, a decrease in the amount of revenue raised – across the UK falls in VAT, fuel duty and business rates were the main contributions to a fall in revenue. Overall, London continued to raise the most revenue per head at £18,430, but also had the most expenditure per head at £19,230.

London flight numbers increase despite staff
shortages

Passenger numbers at Heathrow airport fell to near zero at the start of the pandemic, and have been picking up steadily since early last year. By May of this year passenger numbers still remained 21% below their level in May 2019 (Figure 5). To meet increasing demand Terminal 4 has re-opened. It looks, though, as if capacity may not be sufficient to meet the surge in demand over the summer. Airlines did not retain skilled staff after the furlough scheme ended in September, recruitment has not kept up with demand, and the Government has not been willing to loosen Brexit-related immigration rules to allow airlines to transfer staff from their EU-based operations. Airport ground-handling companies are also seeking to fill thousands of jobs – Swissport lost 20,000 of its 65,000 workers during the pandemic, and is now looking to hire another 30,000. The European air traffic control agency, Eurocontrol, has said that some of the continent’s control centres would struggle to handle all flights in the period to mid-July. In response to these pressures, Heathrow airport has asked airlines to cut passenger numbers at certain times of the day over the summer to ease queues in terminal buildings at check-in. Gatwick airport will limit the number of daily take-offs and landings to 850 in August – about 50 more than the average in early June, but more than 10% below its pre-pandemic maximum.

Figure 5:

GLA Economics will continue to monitor 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.