Positively, the economy’s resilience so far this year translates into an upgraded forecast for 2023, with the economy now expected to grow 0.4%, up from the 0.2% growth forecast in April. The economy remains on course to avoid recession, although the 2025 GDP growth forecast has also been downgraded, from 2.3% to 1.7%.

The EY ITEM Club expects two further interest rate rises from the Bank of England, in August and September, with Bank Rate forecast to peak at 5.5%, before rates start to be cut from the second half of next year. Inflation is still forecast to fall quickly in the second half of 2023, building on June’s downside surprise, but is now predicted to end the year at just below 5%  in April, it had been expected to end 2023 around 3%.

Hywel Ball, EY UK chair, said: “The economy is moving past the series of shocks which have buffeted it in recent years, but their repercussions are long-lasting and holding back UK growth. Inflation remains high, energy bills are a long way from their pre-pandemic levels, and workforce growth has been slow in recent years, partly due to falling inward migration from the EU and a recent uptick in long-term ill health.

“There are bright spots though. While the UK workforce may be smaller than past trends would imply, it has grown back to its pre-pandemic size. Energy costs are falling and supply chain problems are easing. Business investment, which has been disappointing for some time, is starting to outpace the wider economy too. The foundation for growth is there, but the big question mark is the future path of inflation and interest rates.”

The EY ITEM Club says that the UK’s economic outlook will be determined by the face-off between the drag from increased interest rates on the one hand, and the boost to activity from cheaper energy, easing supply chain pressures, and a growing workforce on the other.

The impact from the recent rate-raising cycle – which has seen the biggest increase in Bank Rate over an equivalent period since 1989 – is expected to be significant and long-lasting. The EY ITEM Club’s model indicates that every 25-basis point increase in Bank Rate reduces GDP growth by 0.1% to 0.2% after around 18 months. Meanwhile, around two million additional households will come to the end of a fixed-term mortgage over the second half of this year and during 2024, and will face significantly higher future borrowing costs.

However, higher interest rates are one of a number of factors which should drag what has been stubbornly high inflation downwards over the rest of this year. Energy prices are falling significantly, pipeline price pressures have started to fall in absolute terms, household and business inflation expectations are falling, growth in the money supply has slowed, a stronger pound will bear down on import prices, and the balance between labour demand and supply is moving in favour of the latter. Food inflation is expected to fall to 6% by the end of the year, from just over 17% in June.

Overall, inflation is expected to average 7.6% this year (up from April’s 6.2% forecast), before falling to 3.4% in 2024 (up from 2.5%) and 1.7% in 2025. The Bank of England isn’t expected to reach its 2% inflation target until late 2024.

As a result of sticky inflation, a recovery in real household income is likely to be weaker than expected, and annual wage growth isn’t expected to outstrip annual average inflation until 2025 - later than April’s forecast of 2024. Average earnings are expected to grow 5.8% this year (up from 4.2% in April), 3.1% in 2024 and 2.6% in 2025.

With higher interest rates making mortgages more expensive, house prices are expected to stagnate in 2023, before falling by 4% in 2024. This would facilitate a 10% decline in house prices from their highest to lowest point over a two-year period, as previously predicted in the Spring Forecast. Low unemployment, relatively high savings and lender forbearance should help limit ‘forced sales’ and provide some support to prices.

Martin Beck, chief economic advisor to the EY ITEM Club, added: “The inflation and interest rate outlook is a key risk for the forecast. Should inflation prove more stubborn than expected, the prospect of even more rate rises than we expect will come very much into play. On the other hand, the potential is there for inflation to fall faster than expected, as June’s outturn demonstrated.

“At the moment, the boost from less expensive energy in particular means the EY ITEM Club doesn’t believe recent interest rate rises will push the consumer sector or wider economy into recession. And although the current rate rising cycle doesn’t appear to be over yet, current market expectations for Bank Rate to climb to around 6% seem unlikely to come to pass.

“That said, how the Bank of England perceives things will be key and, should it opt for a more hawkish stance, there is a real risk that interest rates could continue to ratchet up to a level where even the protection afforded by healthy household and business balance sheets isn’t enough to prevent a recession. On that count, the next few months – and what they tell us about just how sticky inflation and strong pay growth are – will be crucial.”

The slightly improved GDP outlook for 2023, alongside falling inflation and improving confidence, means the consumer spending forecast for this year has been upgraded from the 0.3% contraction expected in April to a flat 0%.

However, the slower than expected recovery in real household incomes and the delayed impact of rising interest rates mean the 2024 consumer spending forecast has been downgraded to 0.6% growth from the 1.8% growth expected in the spring. As pressure on real incomes from inflation diminishes and the Bank of England cuts rates back, consumer spending is forecast to rise 1.7% in 2025 (down from the 2.4% forecast in April).

Positively, the EY ITEM Club expects unemployment levels to stay low, albeit the forecast peak has increased slightly to between 4% and 4.5% in 2023, up from predictions in the Spring Forecast of a peak of just over 4%.

Meanwhile, there are some reasons for optimism over business investment which, while still growing slowly, has started to run ahead of GDP. Supported by a strong start to the year, business investment is forecast to rise 1.4% in 2023, a significant upgrade on the 0.3% fall projected in the Spring Forecast. However, the overall GDP downgrade for 2024, plus the drag from higher interest rates, means business investment growth is expected to slow to only 0.4% next year (down from 2.3%), but acceleration to 4% growth is forecast for 2025.

The EY ITEM Club says the 100% expensing for plant and machinery introduced earlier this year has provided support to business investment prospects, which are being further boosted by the falling price of energy. However, these gains are likely to be counterbalanced to some extent by a rise in the cost of capital resulting from higher interest rates.