Tougher years ahead for UK economy as ‘sugar rush’ begins to fade, says EY ITEM Club

The EY ITEM Club says that over the past year consumers have enjoyed a ‘sugar rush’ as falling commodity prices pushed inflation down to zero. However, a combination of rising inflation and a tightening fiscal policy will see consumer spending growth slow from 3% in 2015 to 2.6% in 2016 and 2.1% in 2017.

The forecast predicts that the recent upturn in productivity will continue, as firms use their strong financial position to step up investment. This, in turn, should allow wage growth to continue to steadily accelerate and help firms to weather the impact of the National Living Wage.  As a result, the EY ITEM Club expects GDP growth to reach 2.5% this year before it slows to 2.4% in 2016 and 2.3% in 2017.

Inflation is forecast to start rising this winter but will remain below the MPC’s 2% target until 2018.  

Harder to win growth lies ahead

Peter Spencer, chief economic advisor to the EY ITEM Club comments: “UK consumers should continue to make hay on the back of low inflation until the winter. But as prices start to pick up and the Budget squeeze begins to take effect in April next year, consumers will feel the effects in their pockets and spending growth will inevitably slow.

“We expect the UK economy to continue its strong performance. However future growth will depend heavily on hard-won productivity gains rather than the easy wins from energy and commodity price falls that have played an important role in supporting demand so far.”

Stuart Wilkinson, partner at EY in Cambridge, adds: “UK productivity is set to improve, but to accelerate growth businesses will need to step up their efforts to improve their operations. After years of relying on offshoring, outsourcing and plentiful labour to reduce costs, the ability of businesses to drive real change in their activity now comes to the test.  

“Of course, whilst labour has been plentiful generally, in the East of England region we know there are some sectors who have struggled to recruit, especially at the highly skilled end of the market.”

Earnings inflation is warm enough for the consumer...

The EY ITEM Club expects the pace of wage growth to continue to accelerate, partly as a result of the introduction of the National Living Wage. However, this should act as a spur for companies to continue to drive gains in productivity. Average earnings are expected to grow by 2.9% this year, before jumping to 3.6% in 2016 and 3.7% in 2017.

In part reflecting more expensive labour force, the EY ITEM Club also forecasts increasing levels of investment by UK firms. Business investment is set to rise by an average of 6.1% a year from 2015 to 2020, when it is expected to reach a record high of 11.6% of GDP.

Peter Spencer adds: “In the early stages of the recovery, the strong growth in the supply of labour, partly a consequence of many of us delaying retirement, subdued wage growth. Now the UK economy is transitioning to a more normal recovery, in which real wages and productivity are both recovering.

“As part of this transition we should also see increasing levels of business investment. The recent falls in real wages encouraged firms to employ labour rather than capital to meet increases in customer demand. But, higher real wages will mean that investment is increasingly important as a way of expanding output.”

...but not too hot for the MPC

Despite an acceleration in earnings growth, the EY ITEM Club says that interest rates should remain on hold until next autumn provided that productivity also picks up. As a result, interest rates are expected to end 2016 at 0.75% and 2017 at 1.5%.

Peter Spencer comments: “The MPC will be watching the labour market closely for signs of overheating. However, higher productivity growth should keep unit labour costs under wraps. Provided that happens it should stay the MPC’s hand on interest rates until next autumn.”

Despite risks bright spots remain for UK exporters

Peter Spencer concludes: “Risks to the emerging markets and the world economy have loomed ever larger over the last two years, but have been overdone. In China, despite recent economic wobbles, service industries and consumer spending, which offer some of the best opportunities for UK exporters, are still performing strongly. Equally, UK exports to traditional markets have seen an increase in demand, with exports to the US being particularly strong since last winter. UK businesses will have to tap into these overseas markets to counter the slowdown in domestic demand.”

 

About EY ITEM Club

The ITEM Club is the only non-governmental economic forecasting group to use the HM Treasury’s model of the UK economy. Its forecasts are independent of any political, economic or business bias and this independence is underpinned by the untied sponsorship of Ernst & Young LLP.

ITEM stands for Independent Treasury Economic Model.  HM Treasury uses the UK Treasury model for its UK policy analysis and Industry Act forecasts for the Budget. ITEM’s use of the model enables it to explore the implications and unpublished assumptions behind Government forecasts and policy measures.  Uniquely, ITEM can test whether Government claims are consistent and can assess which forecasts are credible and which are not.   

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Hannah Forrester
EY Media Relations
+44 (0)121 535 2997
+44 (0)7931 491 342
HForrester@uk.ey.com
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