How the Bank failed to diagnose declining GDP

The post-covid economic rebound has not gone to plan. Tim Wallace and Louis Ashworth report

‘Countries around the world are seeing slowing growth, and the UK is not immune from these challenges’

‘Real wages also likely will decline further in May and June, given sharp increases in fuel and food prices’

The economy is shrinking faster than the Bank of England expected, even as prices rise by more than it had anticipated, as stagflation engulfs the country.

Britain’s recovery from the pandemic has been fully derailed by the cost of living crisis, which was on course to be severe even before Vladimir Putin’s invasion of Ukraine sent the global prices of energy, food and other key commodities soaring.

Inflation in the UK hit a 40-year high of 9pc in April and is predicted to break into double figures later this year. GDP, meanwhile, dropped by 0.1pc in March and 0.3pc in April, raising fears of a recession.

Yet the Bank had thought the economy would still be growing, albeit weakly. In its downgraded forecasts last month, officials predicted the UK would eke out growth of 0.1pc this quarter, with a contraction only taking hold at the end of the year after October’s expected 40pc rise in the household energy price cap.

Instead, analysts now think GDP will fall this quarter by between 0.5pc and 0.7pc. It marks a significant shift in expectations over a very short period. So why were the forecasts so wrong?

Rishi Sunak implied global factors beyond his control were to blame for April’s dire drop.

“Countries around the world are seeing slowing growth, and the UK is not immune from these challenges,” the Chancellor said.

Boris Johnson pointed to “an inflationary price bump”, and said Britain may look weak in relative terms on the international stage because “other countries are now catching up” in their post-covid recoveries. The Prime Minister predicted “we’ll get through it very strongly indeed”.

Global factors are certainly involved. The Bank estimates 80pc of the inflation overshoot – the gap between its 2pc inflation target and the 9pc at which prices are rising – is imported.

The surprisingly weak performance of manufacturing, which shrank by 1pc on the month and is still 2.2pc smaller than it was pre-pandemic, is because of the painful combination of Chinese lockdowns limiting supplies and gumming up global shipping, and bills surging on imported energy costs.

Martin Beck at the EY Item Club says the situation in China has been more persistent than anticipated, while petrol prices rose further than predicted, both piling pressure on manufacturers.

Importantly, however, two critical domestic factors are about to get worse.

The first is the end of Covid healthcare spending, which has persistently surprised economic forecasters more used to predicting slow-moving financial forces than monthly variations in the demands a pandemic puts on state resources.

Just as last year GDP was propped up by spending on free tests and vaccines, so this year recorded output is being undermined by its withdrawal.

Since the schemes began in 2020, Test & Trace (T&T) and the vaccine programme have put a significant spin on the headline monthly GDP growth number.

The effect has been to bifurcate gauges of Britain’s growth: there is the headline number, which captures output across all sectors including T&T and vaccines, and a shadow index, which shows the performance of the underlying economy. The former has flattered the UK’S recovery. On a total basis, output returned to its January 2020 level late last year. When excluding the programmes, however, it only did so in March.

It also creates immense month-tomonth volatility, making it harder to predict growth. Before the pandemic, economists were usually good at predicting month-on-month GDP based on data tracked by Bloomberg.

In the 18 months before Covid struck, aggregate predictions were about 0.1 percentage points off the actual numbers on average. Since Covid, the average gap has been five times bigger.

The winding down of T&T and the vaccine programmes since the start of this year has meant the headline growth figure has repeatedly undershot the underlying change. In March and April, that resulted in negative readings of 0.1pc and 0.3pc. Without the schemes, both months would have seen growth.

The Office for National Statistics says a wind down from £1.27bn of spending on the programmes to £490m took half a percentage point off overall growth in April.

The second domestic factor is tax rises, which have come at the same time as a cost of living crisis.

Sunak increased the rate of national insurance charged to businesses and their workers from April, but the effect on wages will hit home in May’s spending, according to Samuel Tombs at Pantheon Macroeconomics.

“The impact of the 1.25 percentage point rise in national insurance contributions on households’ spending won’t emerge in the GDP data until May, given that most workers are paid towards the end of the month,” he says.

“Real wages also likely will decline further in May and June, given sharp increases in fuel and food prices.”

This is particularly worrying given consumer spending was one of the few bright spots in April’s GDP figures, with retail sales growing and hairdressers reporting particularly strong demand. If consumer spending drops with the squeeze from rising prices and taxes, a recession threatens even before the winter crunch which the Bank predicts.

Goldman Sachs, for instance, has cut its second quarter forecast from zero – complete stagnation – to contraction, anticipating a 0.6pc drop in GDP “given the increasing signs of consumer weakness setting in”.

George Lagarias, economist at Mazars, says: “For an economy where consumption is so central, the signs going forward are disconcerting.

“Technically, we may not yet be in a recession, but for many consumers it certainly feels like one.”