An economy shifting back into balance

Joint With Hywel Ball, EY UK Chair and UK&I Managing Partner, Ernst & Young LLP.

We thought long and hard about requesting the EY ITEM Club to postpone their Autumn Forecast until after what must be one of the most talked about Budget announcements in history: the first for this new Government, who won with a huge majority but now has a very long to do list. On balance, we decided to stick to our usual October date for the forecast. The reality is that when Government taxes and spends around ￡1 trillion a year, a few billion here or there on taxes or spending is unlikely to move the dial dramatically from a macro-perspective — however, important it can be for the businesses or households impacted. Hence, we stuck with the date, and may be hostages to fortune!

The health of the macroeconomy is, of course, important to the Government and its fiscal position. Here there has been some (reasonably) good news this year. The economy bounced back in H1 24 from its mini-recession at the end of 2023, and the growth rate has dipped a bit through the summer, the latest EY ITEM Club forecast is for GDP to grow by 0.9% this year — a marked improvement to the 0.3% achieved in 2023. Growth should accelerate further to hit 1.5% in 2025, and 1.6% in 2026 — although this has revised down from our Summer Forecast — reflecting a more cautious outlook on the level of unemployment in the labour market, and from the ONS to the amount of disposable income that households decide to save.

This recovery has been supported by steadily falling inflation — hitting 1.7% in September —below the Bank of England’s target of 2%. This opens the way to further reductions in interest rates, following the 0.25 ppts reduction in August. However, with core inflation still at over 3%, the EY ITEM Club remains cautious about the pace of the reduction in rates; with perhaps just one more 0.25 ppt cut this year in November, and with steady reductions in 2025. Healthy real income growth and lower interest rates will ease the pain on household budgets and corporate P&Ls, while lower rates in particularly should get capital markets moving.

If the Government’s macroeconomic inheritance is better than it hoped, in contrast, the challenge facing its fiscal position has not been overstated. The twin hits of COVID-19 and the energy crisis, saw Government borrow an extra ￡400bn in just over two years. This has taken debt as a percentage of GDP over 100%; the highest it’s been since the early 1960s when the UK was still paying down the costs of the Second World War. With interest rates at 5%, Government is paying debt interest service payments of close to ￡90bn a year — almost 10% of total Government spending. At the same time, there are multiple spending demands from Government departments ranging from Health to Defence to Transport, reflecting the fall-out from COVID-19, a changing global geopolitical environment, and arguably the impacts of the Coalition Government’s austerity programme that saw big reductions in capital budgets.

It is in this context that the new Government is looking at revenue raising measures to help fill the coffers, amendments to the fiscal rules to provide some scope for increasing investment spend, and hoping for a more benign economic environment (particularly on inflation and interest rates) as well.

As a thousand economic and political analysts have already commented, the key to solving this set of challenges is faster economic growth, something that has been an issue for the UK really since the global financial crisis. To do this requires recognition of some difficult trade-offs — more Government investment is required, private sector investment should be incentivised through de-regulation, particularly around planning rules, and the long-term challenges in the labour market on skills and participation need to be addressed. There is a growing consensus in the UK as to ‘what’ is the problem, the number one policy question for the new Government is how to fix it.

Read the full Autumn Forecast: www.ey.com/uk/ITEM.