United Kingdom: Domestic strength, external worries Global Economic Outlook, Q4 2015

After a long period of austerity, things are looking up for UK consumers, with rising incomes and low inflation. Growing demand may well offset global instability and China’s slowdown to make the country a European bright spot.

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The global recovery has been punctuated by a series of shocks that, at times, slowed activity and sometimes threatened to derail it. From the US debt crisis to worries about the breakup of the euro area, Western policymakers have had to contend with a string of shocks. The latest is China’s slowdown and a more generalized weakness in emerging markets. Financial markets took the US Federal Reserve’s (Fed’s) decision not to raise interest rates at its September meeting as confirmation that US growth—and growth in the rest of the industrialized world—is vulnerable to China’s slowdown.

In the United Kingdom, there are signs that external weakness and a strong British pound are having some dampening effect: Manufacturing output has slowed, and surveys of manufacturers point to no improvement in the near term. Net trade unexpectedly contributed to a rebound in second-quarter UK activity, but this seems unlikely to last. Indeed, hopes of an export-led recovery look ambitious in the current environment.

A collapse in food, fuel, and transport costs, along with a strong pound, pushed year-over-year UK inflation down to zero in August.

Yet elsewhere the United Kingdom seems in decent shape. Lower commodity prices are a headache for producing nations such as Saudi Arabia, Russia, and Brazil, but a boon for the commodity-consuming countries of the West. A collapse in food, fuel, and transport costs, along with a strong pound, pushed year-over-year UK inflation down to zero in August. At the same time, a tight labor market is, at last, putting upward pressure on nominal earnings. The interaction of flat inflation and accelerating wage growth means that real earnings are growing at the fastest rate in eight years (figure 1). Falling interest rates on mortgage and consumer credit have given the consumer sector an additional tailwind.

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After a long period of consumer austerity, with spending battered by sluggish or declining earnings, things are looking up for UK consumers. In August, consumer confidence reached the highest level in 15 years.

The government has responded to emerging-market risks by pushing back the timing of interest rate rises. In August, Bank of England Governor Mark Carney repeated a well-worn formulation that the decision on UK rate rises would come “into sharper relief around the turn of the year.” This was widely interpreted to mean that rate rises were likely by late 2015 or early 2016. Yet by late September, following the Fed’s decision to keep rates near zero, the message abruptly changed: Bank of England Chief Economist Andy Haldane said that the next move in UK interest rates was as likely to be a reduction as a rise. Financial markets took notice and have priced in a less aggressive path for tightening—just as, when faced with previous external shocks, the central bank is leaning against the dampening effect on UK growth of emerging-market weakness by driving down interest rate expectations. With headline inflation flat on the year and core inflation at just 1.0 percent (figure 2), the central bank can afford to take its time in raising rates. The selloff in the UK equity market and slackening house price inflation further ease the need for immediate rate hikes.

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Most opinion polls currently point in the direction of a vote to remain in the European Union, but that outcome is not guaranteed.

The United Kingdom has been on the sidelines of the euro crisis and the more recent Middle Eastern migrant crisis. These events have seized the world’s attention, but they may well also influence UK public attitudes toward the European Union. The UK government is committed to holding a referendum on EU membership before the end of 2017; at the moment, the most likely dates for the vote appear to be around June or autumn of next year. Most opinion polls currently point in the direction of a vote to remain in the European Union, but that outcome is not guaranteed. As the vote gets nearer, the issue may well exercise a growing effect on business sentiment, especially if the polls show a narrowing lead for the “yes” vote.

Despite political risks and external uncertainty, the momentum of domestic demand seems likely to sustain UK growth well into 2016. Our assumption is that the United Kingdom should post GDP growth around the 2.5 percent mark this year and next. This is a respectable if unspectacular performance, though it would be enough to put the country near the top of Europe’s not terribly impressive growth league.