UK economy contracts 0.1% in May amid interest rate warnings

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The UK economy contracted by 0.1 per cent in May, less than expected, but economists warned that recent interest rate rises would hit growth in the second half of the year.

An extra bank holiday to mark the King’s coronation contributed to the fall in UK gross domestic product between April and May, Office for National Statistics data showed. Economists polled by Reuters had expected a 0.3 per cent drop.

But Suren Thiru, economics director at the Institute of Chartered Accountants in England and Wales, said the 0.1 per cent fall, which followed a slight rise in May, confirmed “that the economy was floundering even before the impact of recent interest rate rises are fully felt”.

Sterling rose 0.6 per cent against the dollar on Thursday, hitting $1.3063 — its highest level since April 2022 — as traders bet on several more interest rate rises from the Bank of England, but just one more from the Federal Reserve.

The Bank of England has increased its policy rate from a historic low of 0.1 per cent in November 2021 to 5 per cent today, with markets pricing in a further rise to 6.25 per cent by the end of the year.

Thiru added that, while GDP could rebound in June, “the significant squeeze on activity from high inflation, stealth tax hikes and rising interest rates” posed problems for Prime Minister Rishi Sunak’s pledge to deliver economic growth this year.

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The UK economy has been largely flat for the past year as high inflation and rising borrowing costs weigh on household finances and business activity. In May, output was only 0.2 per cent above the level in February 2020, at the start of the coronavirus pandemic.

Thursday’s ONS data showed that output in the three months to May was unchanged compared with the previous three-month period — marginally better than a 0.1 per cent contraction forecast by analysts.

Paul Dales, economist at Capital Economics, said he expected the economy had grown marginally during the three months to June.

However, he forecast that the surge in mortgage rates due to the BoE’s tightening would “contribute to GDP falling in Q3 and a mild recession beginning”.

This week, the average rate on a two-year fixed mortgage hit 6.6 per cent, the highest level since 2008, and the BoE said monthly payments would rise by £500 or more for 1mn households by the end of 2026.

Dales said he did not expect that the BoE would be deterred from further interest rate rises to bring down inflation, which at 8.7 per cent for the year to May is much higher than in the US or the eurozone.

Official data this week also showed that UK wages grew faster than expected in the three months to May.

Commenting on the ONS data, chancellor Jeremy Hunt said: “While an extra bank holiday had an impact on growth in May, high inflation remains a drag anchor on economic growth.”

Industrial production output fell 0.6 per cent during the month and was the largest contributor to the overall fall in GDP. Output fell in eight of 13 manufacturing sectors, with wood and printing among the largest negative contributors.

Construction fell 0.2 per cent in May, the third consecutive drop, with the ONS indicating a slowdown in private housing linked to customers’ economic worries as mortgage rates rise.

Darren Morgan, ONS director of economic statistics, said the extra bank holiday in May for the coronation had affected growth. “GDP fell slightly as manufacturing, energy generation and construction all fell back with some industries impacted by one fewer working day than normal.”

He added that despite the coronation bank holiday, sales had fallen at pubs and bars after a strong April while employment agencies experienced another poor month.

Services were flat overall, with less impact from strikes than in the previous month. After widespread strikes by doctors in April, output in the health sector rebounded 1.1 per cent in May, while continued industrial action in transport contributed to a subdued 0.1 per cent rise.