Hold interest rates until late 2018 to support stalling economy, says EY ITEM Club

With the UK economy looking set to remain stuck in low gear for the rest of this year and well into 2018, the Bank of England’s Monetary Policy Committee (MPC) should keep interest rates on hold until late 2018 to avoid weakening the fragile economic outlook, says the latest forecast from the EY ITEM Club.

The EY ITEM Club’s Autumn forecast predicts that GDP growth will be limited to 1.5 per cent in 2017 and 1.4 per cent in 2018, although activity will gradually strengthen towards the end of next year.

However with expectations high that interest rates may rise from 0.25 per cent to 0.50 per cent this November, the EY ITEM Club is urging the MPC to wait until the UK’s economic prospects look brighter and there is greater certainty over the Brexit transition arrangements, which will support levels of business investment.

Howard Archer, chief economic advisor to the EY ITEM Club, said: “We are far from convinced that raising interest rates this year is the recommended course of action. We believe that it is still likely that inflation will fall back markedly through 2018 as the impact of sterling’s past drop fades and domestic price pressures are limited by lacklustre growth, with only a gradual pick-up in earnings. Brexit uncertainties are also likely to remain elevated well into 2018 and perhaps beyond.

“While it is understandable that the MPC will want to gradually normalise interest rates from their current ‘emergency levels’, we believe it would be better to do so once the economy is on a stronger footing.”

If interest rates do rise this November, as seems most likely, it is probable that the MPC will tread very carefully on further increases.

The EY ITEM Club believes that the MPC will not act again until Q4 2018 when it forecasts that an improving economy, helped by progress towards a Brexit transition deal and reduced squeeze on consumers, will see interest rates lifted to 0.75 per cent.

Thereafter, the EY ITEM Club sees the Bank of England increasing interest rates very gradually to 1.25 per cent by the end of 2019, 1.75 per cent by the end of 2020 and 2.25 per cent by the end of 2021.

The EY ITEM Club expects the economy to continue to struggle for momentum during Q4 2017 and early in 2018. Consumer price index (CPI) inflation reached 2.9 per cent in August and is forecast to climb just above 3 per cent during the final months of 2017, which will maintain the squeeze on consumers. The forecast then expects CPI inflation to fall back markedly during 2018 and to end the year back down around 2 per cent as the impact of sterling’s sharp drop in the second half of 2016 increasingly fades. This should progressively support consumer purchasing power, while earnings growth is expected to pick up gradually - helped by a relaxation of the Government’s public sector pay cap.

If the UK and EU make sufficient progress in their Brexit negotiations to agree a transition agreement in the latter months of 2018, it should boost business confidence and support a gradual pick-up in investment. The EY ITEM Club forecasts that this should help GDP growth improve to 1.8 per cent in 2019 and 2.0 per cent in 2020, and will see business investment rise 1.5 per cent in 2018, after an increase of 2.1 per cent in 2017, and then hit 2.7 per cent in 2019.

Mark Gregory, EY’s chief economist, said: “The economy has not fallen off a cliff as some forecasts around the impact of Brexit predicted, but growth is slow and the risks are weighted towards the downside, with Brexit and the labour market providing the most significant areas of uncertainty. It would be sensible for businesses to consider these risks as part of their planning, particularly given the potential for an adjustment period after Brexit while the economy comes to term with the changes.

“The consumer sector remains under the most pressure with inflation, low wage rises, welfare cuts and a slow housing market all acting as drags on consumer spending. Consumer and retail businesses are also dealing with the challenges of major disruption from online in their sectors. It may be time for these businesses to undertake an in-depth review of the fit of their business models in this emerging environment.”

According to the forecast, personal consumption growth slowed sharply during the first half of 2017 after reaching a nine-year high of 2.8 per cent in 2016. While the squeeze on consumers remained appreciable, there may have been a modest pick-up in spending in Q3 2017, helped by more people staying in the UK for the summer holidays and tourists being encouraged to spend by the weakened pound.

The forecast expects consumer spending growth to slow from 2.8 per cent in 2016 to 1.5 per cent in 2017 and to be limited to 1.1 per cent in 2018.

However, the forecast predicts that consumer spending will pick up gradually in quarter on quarter terms during 2018 with growth rising to 1.6 per cent in 2019.

Mr Archer added: “The squeeze on consumers is likely to continue, reflecting elevated inflation and weak pay growth. Pressure on purchasing power should increasingly ease as 2018 progresses, largely due to an expected retreat in inflation to 2% by the end of the year. There is also likely to be a gradual pick-up in pay in both the private sector and the public sector. However, there is a risk that employment growth could lose momentum.”

Mr Archer concluded: “It is clear that the economy’s performance in 2019 and beyond will depend critically upon the UK concluding a transition arrangement with the EU. Although the next few months should bring greater clarity here, this continues to be the number one risk, in addition to ongoing political uncertainty.”