(Sept 13): The UK economy shrank at the fastest pace in seven months in July, as strikes and wet weather hit activity harder than expected, reviving fears that a recession may be under way.

Gross domestic product slipped by 0.5%, following a 0.5% gain in June, the Office for National Statistics (ONS) said on Wednesday. Economists had expected a contraction of 0.2%. Services, construction and manufacturing all shrank.

Britain’s economy, which the Bank of England (BOE) expects to stagnate at best for much of the next two years, is now losing steam in the face of a sharp increase in borrowing costs. That may give policymakers a pause for thought when they decide next week whether to raise interest rates again in their fight to tame inflation.

“Underlying growth has lost momentum since earlier in the year,” said Paul Dales, at Capital Economics, noting a mild recession may in fact have begun. “These data suggest gross domestic product (GDP) growth in the third quarter as a whole is likely to fall well short of the BOE’s 0.4% quarter-on-quarter forecast.”

That’s bad news for UK Prime Minister Rishi Sunak, who faces the prospect of a general election next year, with his Conservative Party lagging far behind the Labour opposition in opinion polls. Chancellor of the Exchequer Jeremy Hunt said the UK is doing well compared to other countries.

“There are many reasons to be confident about the future. We were among the fastest in the Group of Seven to recover from the pandemic, and the International Monetary Fund (IMF) have said we will grow faster than Germany, France, and Italy in the long term,” Hunt said in a statement. 

In an interview on Bloomberg Radio, Gareth Davies, the exchequer secretary to the Treasury, said economists had been too gloomy.

“Not too long ago, a lot of the forecasters were saying that a recession by now, and that hasn’t happened,” he said. “The IMF, Bank of England and the Office for Budget Responsibility all upgraded their forecasts for growth.”

The pound fell to a three-month low after the release, falling as much as 0.4% to US$1.2442. Yet the data did little to change the outlook for rates traders, with money markets pricing a quarter-point hike to 5.5% by November — little changed on the day. Odds still favour another increase to 5.75% by year end. BOE governor Andrew Bailey has signalled that the most aggressive hiking cycle since the 1980s is almost complete. 

While most economists had expected the UK to eke out modest growth in the third quarter, the scale of July’s decline makes a contraction more likely. Bloomberg Economics thinks the UK may now be in a recession that will persist through much of 2024.

“Today’s data supports our call for the BOE to keep interest rates steady next week to give time for its medicine to work rather than risking an overdose,” said Kitty Ussher, the chief economist of the Institute of Directors. She urged the BOE to forgo a 15th consecutive rate hike next week.

The main cause of the contraction was the dominant services sector, which fell 0.5% in July. Cool and rainy weather depressed retail sales during the month. Output was also dented, as doctors, teachers and rail staff walked off the job in their disputes with the government over pay.

“The broader picture looks more positive, with the economy growing across the services, production and construction sectors in the last three months,” said Darren Morgan, the director of economic statistics at the ONS. 

Activity in the information and communications sector also fell in July, particularly in computer programming and consultancy, after three consecutive months of growth. The ONS said strikes held back recruitment, especially in the NHS. Wet weather hurt retail sales, construction and outdoor venues.

Offsetting the falls in health, consulting and retail was a big increase in recreational experiences as people went out. The arts, recreation and entertainment sector grew by 6.6% — the best growth since May 2021. Within that, sports, amusement and recreation activities grew by 12.4%, while creative, arts and entertainment grew by 4.9%.

There were also declines across other sectors, including construction and industrial production.

Manufacturing activity was the biggest downwards contributor to production, following strong growth a month earlier. Manufacture of rubber and plastics products and other non-metallic mineral products was the largest contributor to the fall, followed by computer, electronic and optical products.

In construction, households cut back on repair and maintenance, in a sign that inflation is eating into incomes. The sector shrank 0.5% as a whole, largely due to a fall in demand among private housing. There was also a slowdown in the house-building sector. The ONS said the unusually cold and wet July weather may have been to blame.

Data on Tuesday showed the labour market, closely watched by the BOE for signs of persistent inflation, is cooling down.  

The latest GDP estimate may well be revised later this month, when the ONS will release new estimates consistent with its “Blue Book” changes. 

Those changes rewrote the narrative of the pandemic, with the economy larger than previously thought at the end of the 2021 and above pre-Covid levels. However, they provided no guide to how the economy has fared since then, a period of rising inflation and interest rates.

“Higher interest rates and sticky inflation are having a more significant effect on the economy,” said Neil Birrell, the chief investment officer of Premier Miton. “All eyes will be on the bank for the announcement of the rate decision.”