UK economy left on ‘knife edge’ as rate hike torrent takes its toll

The British economy saw inflation finally abate in 2023 but could still finish with a recession and more pressure from the full impact of the barrage of interest rate hikes, with experts warning that the economy has been left on a “knife edge” heading into 2024.

Inflation became the key battle ground for both the Bank of England and Prime Minister Rishi Sunak in 2023 as soaring prices threatened to inflict long-lasting damage, sparking industrial action on a scale not seen since the 1970s.

In January, Mr Sunak made it one of his five key pledges to halve inflation by the end of the year.

Charged with the seemingly impossible task to bring inflation back down to its 2% target, the Bank continued its relentless campaign of interest rate increases, which took borrowing costs to levels not seen for more than 15 years.

UK Interest rates (PA Graphics). PA Media

Homeowners were hit with 14 hikes in a row, with rates reaching 5.25% in August before the Bank hit the pause button as inflation beat a retreat.

Having started the year at 10.1% in January, inflation fell sharply and by October it eased back to 4.6%, allowing Mr Sunak to declare early victory in achieving his goal.

Inflation continued its steep descent in November, dropping to 3.9% as fuel prices fell and increases in food costs slowed.

But Bank governor Andrew Bailey tempered the Government’s cheer, warning that the battle with inflation was far from over, with still a long way to go before coming back down to the 2% target.

Rather than being driven by policy actions, much of the sharp pullback was also largely driven by this year’s lower energy price cap compared with the £2,500 limit set a year ago.

There was, however, some respite offered to households as soaring food prices and energy costs eased back – and as wage growth finally began outstripping inflation for the first time since 2021.

Yet the worst for many was only just being felt, as the Bank’s torrent of rate rises meant eye-watering jumps in mortgage payments as borrowers rolled off fixed-rate deals.

About half of mortgage holders have already moved to new fixed-rate deals since interest rates started rising in late 2021, amounting to more than five million households.

But a further five million homeowners are still due to face higher borrowing costs by the end of 2026, according to the Bank.

“We might have reached the peak of the interest rate cycle, but we’re not out of the woods by a long shot,” cautioned Laith Khalaf, head of investment analysis at AJ Bell.

Thomas Pugh, an economist at audit and consulting firm RSM UK, said that an estimated 1.6 million households are set to remortgage to sharply higher rates in 2024 alone.

He said this will be partly offset by a rebound in real wages, which should help prop up consumer spending.

“Whilst this should be enough to avoid recession, the economy will remain on a knife edge as it won’t take much of an increase in headwinds to tip the UK into one,” Mr Pugh warned.

He is expecting the UK to “endure another year of stagnation” with growth of about 0.1% a quarter for most of 2024.

“It will likely be 2025 before the economy gets back to any significant increase in growth,” Mr Pugh cautioned.

The Bank is forecasting that the UK will swerve recession in 2024, albeit with zero growth pencilled in, while it does not see Consumer Prices Index (CPI) inflation returning to target until the end of 2025.

But the threat of a recession still looms large.

UK quarterly economic growth (PA Graphics). PA Media

Revised data from the Office for National Statistics found that the UK economy declined between July and September, with a 0.1% drop in gross domestic product (GDP).

It had originally indicated the economy had flatlined over the third quarter.

The surprise contraction reignited the possibility 2023 will finish with a technical recession – defined as two successive quarters in a row of falling output – if there is another decline in the final quarter.

Investec economists had said a recession was on the cards “largely on the lagged impact of higher interest rates”.

“But the recent improvement in survey data gives hope that if there is a recession, this will be relatively shallow and, as inflation keeps receding, short-lived,” said Investec’s Sandra Horsfield.

Despite the Bank’s insistence that rate cuts are not yet on the cards, many experts believe slowing wage growth and sharply falling inflation will give policymakers room to start reducing in the first half of next year.

The rate of unemployment is expected to pick up to 4.8% from 4.2% in the three months to October 2023, according to some economists, as the economic uncertainty takes its toll on the jobs market.

The EY Item Club is pencilling in the first rate cut to be on the cards from the spring of 2024 as it cautions over a “risk that policymakers keep policy too tight as primarily global forces push inflation down”.

While the timing is uncertain, most experts agree that rates are likely to come down in the year ahead.

Mr Khalaf said: “Much of course depends on the path of inflation, which is driven by many variables that are difficult to predict in isolation, let alone together.

“That’s especially against a background of monetary policy going from nought to 60 in a painfully short space of time, with much of the attendant effect on the economy yet to play out.”