Growth in the UK is affected by weaker supply and demand factors

Britain has long been known for the quality of its policies, but if you compare recent months, you can say that it has had its ups and downs. Indeed, Liz Truss set a new record by becoming Britain’s shortest-serving Prime Minister when she stepped down after just 44 days in office. Its main policy mistake was a hastily adopted “mini-budget” that avoided the usual scrutiny of the UK’s Office for Budget Responsibility (OBR).

In terms of policy design, Ms Truss’s budget was anything but a “mini” budget as it attempted to deliver massive policy changes and, crucially, involved larger budget deficits due to unfunded tax cuts. Financial markets reacted aggressively, with the pound falling sharply (Figure 1) and interest rates on UK government debt (gilt) reaching record highs. Indeed, the Bank of England (BoE) was forced to intervene to protect pension funds from bankruptcy as they had taken snowball bets to keep gilt yields low.

As a result, Liz Truss left office and Rishi Sunak became Prime Minister on 25 October 2022, taking the reins of a country facing four significant economic headwinds: fiscal tightening, monetary tightening, the developing European energy crisis, and Brexit-induced shortages on labour.

First, Prime Minister Sunak, himself a former Chancellor of the Exchequer (UK Chancellor of the Exchequer), has already announced significant fiscal tightening, reversing all of Mrs Truss’s policy changes. Sunak and his chancellor, Jeremy Hunt, are seeking a total of £50 billion in tax rises and spending cuts to balance the books. Whatever the details, the new budget must contain significant fiscal tightening to rebuild Britain’s reputation. However, this will inevitably be a significant headwind to UK GDP growth prospects.

Second, the highest inflation in over 30 years (around 10% in September) and weak GDP are forcing the BoE to raise interest rates aggressively. The 75 basis point (bp) hike in November is expected to be followed by further 50 bp hikes in December and February, reaching a maximum policy rate above 4% in 2023. This aggressive monetary policy tightening will coincide with the corresponding fiscal policy tightening mentioned above . As a result, monetary tightening will also be a significant headwind to the UK outlook, with fiscal and monetary policy reinforcing rather than neutralizing each other.

Third, record high gas prices in Europe increase costs for producers, prices for consumers and public spending through support measures such as cross-subsidies and price caps. Leaving the European Union (EU) has given the UK greater policy flexibility, allowing it to respond more proactively to the crisis, including implementing EU support measures for households and businesses faster than EU countries.

Fourth, the supply side of the UK economy is constrained by labor shortages, a legacy of the UK’s decision to leave the EU. Britain’s agricultural, manufacturing and service sectors had all adapted to the abundant and cheap labor available in the Central and Eastern European countries. However, the situation changed with Brexit, which excluded the UK from the EU’s free movement of labor policy. The global Covid-19 pandemic has made the situation even worse, and the UK today faces severe labor shortages across many sectors of the economy. This situation leads to sustained upward pressure on wages and thus on inflation, despite the weakened demand outlook. Therefore, labor shortages are yet another headwind for the UK’s economic outlook.

Overall, Prime Minister Sunak takes over the helm of a country currently facing several economic uncertainties that will continue to disrupt supply and demand at the same time. On the one hand, UK consumers will face a fall in their disposable income. On the other hand, UK manufacturers face higher costs and less competitiveness, which affects their overall profitability. Overall, this will be negative for consumption and investment, limiting growth in the UK in the short to medium term.

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