Given the magnitude of the shock, we still expect a recession in the UK, though perhaps a milder one than would otherwise have been the case. Goods production has already stagnated—it’s only services that have kept gross domestic product afloat lately. That situation will change as persistently negative real income eats into household spending.
Even though the gas price caps will tamp down inflationary pressures, we still see plenty of scope for tighter BoE monetary policy—the difference between 15% and 10% inflation isn’t nearly enough to prevent a sensible central bank from raising interest rates.
The restraint on the BoE to date has been the potential for a deep recession and sharply weakening labor market. The price caps make a severe recession less likely, in our view freeing the central bank’s hands to more aggressively contain inflation expectations and bring inflation to heel sooner. We expect at least another 125 to 150 basis points of rate hikes in this cycle, with forecast risks tilted higher.
Eurozone: Broader Gas-Supply Disruption Is a Risk
The pain from lofty natural gas prices is similarly severe in the eurozone. For now, we believe a mild recession is most likely, with the basic analysis similar to that of the UK. Falling real incomes will limit consumption and production, slowing the economy.
The European Central Bank will nonetheless continue to raise rates as inflation climbs. Europe’s fiscal support has been less comprehensive than in the UK—not surprising, given the more fractious politics involved. However, we believe that policymakers will do what they can over time to reduce the negative impact of rising gas prices on households and critical businesses.
The more worrisome scenario for Europe remains its direct dependence on Russian gas imports. If the war disrupts that supply enough that severe fuel rationing becomes necessary—especially with the onset of winter—the outlook will become much bleaker and a deeper recession more likely. Sum it all up, and while Europe’s weather may still be warm, the economy is cooling fast. Policymakers are doing what they can to ease the pain, but it’s shaping up to be a very difficult winter.