The UK economy is in a period of steady growth and low inflation which should continue in 2016. Economic growth this year should be around 2.5 per cent – very respectable in the post-crisis New Normal, keeping us close to the top of the G7 growth league along with the United States.
Unemployment is likely to continue to fall, with the jobless rate dropping below 5 per cent by the end of the year – for the first time since 2005. As the labour market tightens, wage growth should start picking up again – supported by the introduction of the Living Wage and skill shortages in key sectors, such as construction. With inflation remaining low, wage growth of around 3 per cent or above will continue to deliver higher disposable incomes and support consumer spending.
Another positive factor for UK growth in 2016 should be better growth in continental Europe. The German economy remains strong, Spain is growing at around 3 per cent and Italy now appears to be turning around. Disappointing growth in France will continue to be a drag on the European economy, but this will be offset by good performance in some of the smaller European economies – such as Ireland, Sweden and the Netherlands. Parts of eastern Europe – including Poland – should also continue to perform well.
But Europe could exert a drag on the UK economy in a different way in 2016. A referendum on Britain’s EU membership is likely to be held in the summer or autumn. As in 1975, I would expect there to be a Yes/Remain vote to stay in the EU. But while there are some powerful economic arguments to support that case, the referendum result will be influenced by a wider range of issues and concerns. So the vote could be close, creating uncertainty and possibly causing some investments to be put on hold while businesses wait to see the outcome.
Perhaps the most significant change we are likely to see in the UK economy in 2016 is the start of a gradual rise in interest rates, as the Bank of England follows the lead taken by the US in December. There is not much suggestion of this yet from the Monetary Policy Committee (MPC) – only one member is voting for a change and financial markets are not expecting an increase until early 2017.
However, I expect the first interest rate move to come earlier than that. Since 1990, there have been three significant rate-rising cycles, starting in 1994, 1999 and 2003-4. On each occasion, the Bank of England has raised interest rates within a few months of the Fed.
The economic outlook suggests it will be the same this time around. Projections of growth and inflation for the US and the UK are remarkably similar, as are our unemployment rates. In the absence of a big shock to the economy, I would expect the first rate rise from the Bank of England to come before the summer, and for the official UK Bank Rate to end the year at around 1 to 1.5 per cent. A weakening pound against the dollar and euro could also encourage the MPC to act in the first half of the year.
By the second half of the year, we should also see inflation picking up and it will probably end 2016 close to the 2 per cent target, as the temporary impact of falling oil prices drops out of the calculation and higher wage growth starts to feed through into price increases. That should set the scene for further interest rate increases in 2017 and 2018.