Can policymakers help lift the UK economy?

Latest GDP figures highlight the challenges facing the economy and investors, but both monetary and fiscal policy can do more to help the economy rebound

It has been a lacklustre start for the new Labour government in terms of the performance of the UK economy. Some of the sluggish growth can be attributed to a lack of confidence amongst households and businesses, but a significant part of the blame lies with the absence of detailed policy proposals before the general election, followed by the subsequent increase in taxes.

Recent data suggests that growth may worsen further, but policymakers can still help turn the tide. Faster easing of monetary policy and a carefully calibrated Spring Budget statement could help restore confidence and boost the economy.

The Office for National Statistics (ONS) released its first estimate of the UK’s GDP growth this morning, showing that the economy eked out just 0.1% (q/q) growth in the final quarter of 2024, following zero growth in the third quarter. The services sector of the economy grew by 0.2%, though production (including manufacturing) fell by 0.8%, offsetting most of those gains.

The expenditure breakdown suggests weaker confidence. Real household spending was flat in real terms, while business investment fell by 3.2% - the biggest quarterly drop since the pandemic (Q1 2021).

The headlines from the latest economic performance could have been worse. A significant build-up of inventories meant the economy avoided a sizable contraction during the period, with the change in inventories contributing just over a percentage point to GDP growth.

However, the build-up of inventories is yet another sign of weakness. It indicates that final demand deteriorated in the latest period, but production didn’t slow as much. This often happens when companies cannot predict or adjust quickly enough to a worsening outlook.

Interestingly, the GDP income breakdown shows a nominal decline in economic profits. This aligns with the large build-up of stocks, and it serves as an early indicator that companies may cut production further soon.

Domestic weakness is not the only concern. The total volume of UK exports fell by 2.5% in Q4, and by 2.2% in 2024 overall. While this represents a marginal improvement over the 3.2% fall in exports seen in 2023, the contribution to the UK’s overall trade balance has worsened.

The volume of imports in 2024 rose by 1.6%, compared to a 4.5% drop in the previous year. Imports also rose substantially in the latest quarter, meaning that the contribution from net trade detracted from headline GDP growth by just under 1.5 percentage points.

In fact, the latest figures show only two sources of growth for the real economy. The first is the large build-up of inventories, as mentioned earlier. This is unsustainable, as companies are likely to cut production further in response to weaker demand.

The second source is government spending. Investors had hoped that a new Labour government would substantially increase public spending and investment, stimulating the economy. This is, or maybe I should say, was the plan. It now seems less likely that the government’s spending ambitions can be realised with such a weak economic backdrop acting as a constraint on public finances.

If the economy is going to return to more robust growth, it’s going to need help, especially with the poor external outlook. Europe’s largest economies contracted at the end of 2024, while protectionist trade policies from the new United States administration are likely to further disrupt trade.

Policymakers can do more to help.

The Bank of England (BoE) cut its main policy interest rate by 0.25% to 4.5% at its February meeting. Interestingly, two of the Monetary Policy Committee members voted for a larger cut, pointing to the worsening trends in activity.

With inflation still running above the target at 2.5% y/y, the BoE has been slow to return rates to more normal levels. In its latest Monetary Policy Report, the committee pointed to the possibility of inflation rising in the near term, potentially surpassing the upper target of 3% by the middle of this year, before eventually returning to its central 2% target by 2027. With risks skewed to the upside in the near term, a gradual easing of rates makes a fair amount of sense.

However, the longer interest rates remain restrictive, the greater the likelihood of an inflation undershoot in later years. The economy is already weak, and disinflationary pressures are building.

Beyond the interest rates, the management of fiscal policy can also help to boost growth. I say management rather than expanding as the market already understands the Labour government’s intent to spend more. The concern now is about its ability and willingness to do so, given the worsening economic outlook.

Poor growth means lower tax receipts, leaving less room to manoeuvre based on the Chancellor’s own self-imposed fiscal rules. Does the government therefore pull back from its expansionary plans, disappointing those who expect higher spending and investment, and hurting growth in the process? Or does it proceed and allow for higher borrowing in the near term, running the risk of upsetting markets?

A carefully calibrated public spending plan is needed in the next Budget, along with a contingency plan in case growth disappoints. Capital investment projects need long-term assurances for success, so near-term disappointments due to inflation or growth should not derail these plans. A confident government with a solid plan can help win investor confidence and create the "animal spirits" the UK economy has been sorely lacking.