Is Britain’s economy finally moving?

In its first weeks in office the new Labour government is hammering away at one message: on prisons, the National Health Service, the armed forces and more, the Tories left behind a terrible inheritance. It is no different for the economy. Rachel Reeves, the chancellor, says Labour has been handed the worst economy of any incoming government since 1945, when Britain was loaded with wartime debt and its cities pockmarked with craters.

Much of the gloom is warranted. Britain’s productivity record since the financial crisis has been feeble. Parts of the previous government’s agenda, especially around Brexit, contributed to the sense of stagnation. The public finances are stretched thin. Hence Labour’s emphasis on growth: central to its election campaign was a promise to get Britain’s economy growing faster than any other G7 country’s. Muddying the picture somewhat, however, is the fact that a version of this milestone may already have been passed—under the Tories.

Britain has resoundingly bounced back from its brief recession in late 2023, and at a speedier pace than most forecasters expected. The economy grew by around 1.1% (a 2.3% annualised rate) over the first half of 2024. That compares with 0.8% or so for America and Canada over the same period, and 0.3% to 0.5% for France, Germany and Italy. Throw in Japan’s lacklustre numbers and Britain is likely to have outpaced the rest of the G7 over the final months of Rishi Sunak’s premiership (see chart 1). This expansion was almost entirely services-driven, and was probably helped along by a strong rebound in household borrowing after a painful adjustment to higher interest rates.

That is not the only way in which the picture now looks sunnier. Annual headline inflation is back at the Bank of England’s target of 2%. The main gauges of underlying inflation are also falling, if bumpily (see chart 2). One particular fixation for central bankers is services inflation, thought to better reflect how entrenched inflation has become by peeling away all goods prices, not just those of volatile commodities like food and energy. Some go further and also exclude services like flights and hotels, which can move sharply and idiosyncratically. These declines should tee up a first cut to interest rates, perhaps as soon as the next meeting of the Bank of England’s monetary-policy committee on August 1st. Financial markets expect two quarter-of-a-percentage-point cuts before the end of 2024.

Sterling has also crept back to its pre-Brexit level against a basket of foreign currencies, though it remains weaker against the dollar. The FTSE 100 share index has risen by 5.8% this year, more than in the four prior years combined.

Caution is in order. A few good months, however welcome, cannot undo years of underperformance. At best, it might persuade the Office for Budget Responsibility, a fiscal watchdog, not to nudge down its optimistic productivity-growth numbers, which would make Ms Reeves’s spending choices, already tough, even more constrained. But it is still in everyone’s interests that this growth spurt is maintained. Can it be?

Labour is trying to keep the momentum going with an early blitz of policy announcements. But they will take a while to have an impact. Take Labour’s aspiration to build more houses and infrastructure. Boosters say that the ensuing construction activity will instantly raise growth. But Britain already has a high employment rate and limited appetite for more migration. An investment boom would mean redirecting workers from other (admittedly less productive) projects, dampening the uplift to aggregate growth. What matters more would be the boost to the supply side of the economy if and when all those homes, pylons and wind farms get built. Those gains would raise the growth numbers later and only gradually.

So the question is whether this recovery can carry on under its own steam. One risk is that inflation hasn’t quite been shaken off. Persistent inflation would force the Bank of England to keep interest rates elevated, weighing on asset prices and the economy. Pessimists point to the fact that core inflation (excluding food and energy prices) is still running at a 3.6% annual rate, well above target. Services inflation is even higher, at 5.7%. Overall headline inflation has been flattered by big declines in energy and durable-goods prices, but those are probably one-off drops.

Wages, which feed into inflation, are rising at 5.2% annually, a rate far too high to be consistent with the bank’s target inflation rate. Wage growth on new job contracts, a more forward-looking measure, is still around its peak of 7%, according to a tracker from Indeed, a jobs site (see chart 3); something like 3-4%, which is where America and the euro zone stand on this gauge, would be normal. Ms Reeves is currently deciding whether to accept a 5.5% pay rise for some public-sector workers that has been proposed by independent pay bodies (the Treasury had previously budgeted for 3%).

The other big risk is that growth falters because consumers pull back or because of changes in the labour market. Recently released retail-sales figures for June were well below forecasters’ expectations. More significantly, much of Britain’s labour-market loosening since June 2022 has been due to falling vacancies but unemployment has also started to rise and now stands at 4.4% (see chart 4). Historically, quick rises in the unemployment rate have often presaged recessions. An American economist, Claudia Sahm, formalised this pattern into the “Sahm Rule”, a real-time recession indicator that is met whenever the three-month average of the unemployment rate rises by at least 0.5 percentage points within a year. Britain has now triggered this threshold (though the rule was designed for America and has misfired in Britain before).

If Labour gets lucky, these two risks might offset each other. A softening labour market could pull down inflation and make space for looser monetary policy to buffer growth. But they could as easily knock things off course. A persistent-inflation scenario would be especially troubling. The Bank of England’s credibility has been tarnished but not shattered by the inflation surge Britain has experienced in recent years—another jolt could do real damage.

Real as these risks are, the economy seems to be doing fine for now. The stronger showing complicates Labour’s insistence that its inheritance has been uniquely dire. But listen at the door of Number 11 Downing Street and you may hear sighs of relief. Labour needs the economy to grow faster if living standards and public services are to improve. Just don’t expect it to admit an upswing was already under way. ■

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