2023 is expected to be an exceptionally tough year for the UK economy. The country is almost certainly already in a year-long recession, one that will probably prove to be deeper than that experienced in the early 1990s.

The squeeze on household real incomes will intensify as rising interest rates join soaring inflation.

Admittedly, the Government’s austerity measures won’t harm growth in the short term, according to Thomas Pugh, economist at RSM UK.

“Most of the pain has been delayed until after the next General Election. But they won’t help the economy much in the short term either,” said Pugh.

Not all recessions are created equal

Not all recessions are created equal though. Pugh expects a peak-to-trough fall in GDP of around 2.5 per cent.

“That would be slightly smaller than the early 1990s recession and significantly less than the Global Financial Crisis,” he stressed.

Pugh also anticipates the unemployment rate to rise from the 3.6 per cent it is now, to around 5 per cent by the end of 2023, entailing job losses of about 200,000.

Looking for the good news? Inflation will fall over 2023.

The bad news is that it will probably still average around 7.5 per cent over the whole of next year.

High inflation and a tight labour market will force the Bank of England (BoE) to raise interest rates from 3 per cent currently to around 4.5 per cent early next year, said Pugh, adding that “it will be 2024 before the bank considers cutting rates.”

Ongoing squeeze in real incomes

Households’ disposable incomes have been hammered by the cost-of-living crisis, which has seen inflation soar from 0.5 per cent at the start of 2021 to 10.1 per cent in September 2022 due to the huge rises in food and energy prices.

The Government’s energy price guarantee (EPG) has shielded households and businesses from the worst of the energy crisis, Pugh pointed out.

But he added that utility prices will rise by another 20 per cent in April 2023 when the government’s Energy Price Guarantee for the average annual utility bill rises from £2,500 to £3,000.

“As if that wasn’t enough, the surge in mortgage rates will further sap households’ disposable incomes,” Pugh continued.

Mortgage rates have surged well ahead of the base rate as banks anticipate higher interest rates, meaning that anyone unlucky enough to be mortgaging over the next few months will see the share of their income spent on the soaring mortgage interest.

Pugh singled out the average borrower rolling over a 75 per cent LTV ratio two-year fixed rate mortgage today for another two years will see the proportion of their incomes being absorbed by monthly repayments soar to about 34 per cent, from 22 per cent.

“What’s more, a loosening labour market, as firms reduce hiring and even start to cut workforce numbers, will result in nominal wage growth dropping back to more ‘normal’ levels,” he said.

“Throw in higher taxes potentially worth 1 per cent of GDP and a real terms reduction in public sector pay, and the 2023 outlook is bleak for household’s real disposable income,” Pugh added.

All in, he expects RHDI to contract by 2.5 per cent in 2023. That would be the biggest fall on record.

Admittedly, consumers have, on average, a considerable level of savings, equivalent to around 10 per cent of GDP.

“But given consumer confidence is at a record low, we aren’t expecting them to dip into these savings by much,” Pugh noted.

So, consumers have less money to spend and are less willing to spend it. This will inevitably mean a sharp reduction in consumer spending, especially on discretionary items such as hospitality and retail goods.

“We are expecting a decline of 2 per cent in total consumer spending next year,” Pugh said.

Surging interest rates and slumping demand will also reduce business investment which is still about 8 per cent below its previous level, he continued.

“This is mainly driven by a slump in investment in offices and transport equipment, as demand for office space and travel has not fully recovered because many people have continued to work remotely.”

Inflation slowing but still elevated

The recession will go some way to reducing domestic inflationary pressures. Some leading indicators are already pointing to an easing in domestic price pressures.

With energy price inflation about to turn down decisively, UK CPI inflation will soon start to fall from October’s 41-year high of 11.1 per cent, Pugh said.

In addition to that, the current $80 level of Brent crude oil prices suggests that motor fuel’s contribution to the headline rate will fall to almost zero by March.

“The stabilisation of food prices over the last six months also points to food CPI inflation falling quickly next year,” he noted.

Meanwhile, the plunge in shipping costs and increase in retailers’ stock levels suggests that core goods prices will fall back soon.

“Even so, inflation will remain high for most of next year. We think that inflation will be around 7 per cent in mid-2023, around 4 per cent by the end of 2023, but may fall below the BoE’s 2 per cent target in the second half of 2024.”

However, there is a risk that inflation proves stickier than we think, either because a tight labour market means that wage growth falls more slowly than we expect or because firms are rebuilding margins.

Indeed, the Q4 edition of the RSM UK MMBI showed that middle market firms are getting better at passing on costs.

“That said, the recession and weaker demand will make it more difficult for middle market firms to continue to pass on higher costs,” Pugh said.

With inflation set to remain high throughout 2023, it will be difficult for firms to continue to defend their margins.

And given the recent challenges firms have had in recruiting staff and the relatively short recession, firms will have more of an incentive to hoard labour than in previous periods of economic weakness, he continued.

The exceptionally tight labour market probably explains why, in this quarters MMBI, 41 per cent of firms said they hired more staff in Q4, despite the dire economic outlook.

“Ultimately, we expect the level of vacancies to fall from near-record levels to below one million and the unemployment rate to rise to a peak of 5 per cent by the end of next year, significantly lower than the 8.5 per cent peak reached in the aftermath of the Global Financial Crisis,” Pugh said.

If that were all to come from employed workers becoming unemployed it would mean a loss of about 400,000 jobs.

“But we expect some people who are currently inactive, those not currently looking for work, to come back into the workforce as they seek to boost their incomes,” he said.

This will probably raise the labour market participation rate and mean total job losses could be closer to 200,000.