How the UK fits into a diverging world

For a while, it looked as though Europe, the US and the UK were fighting the same economic bogeymen. Economies were all struggling to normalise after the shock of pandemic-era restrictions, while central banks were locked in a battle against high inflation. But as inflation starts to return to target and economies normalise after the pandemic, fates appear to be diverging. 

We are used to the idea of a ‘two-speed Europe’, but recent forecasts have turned the concept on its head. Analysis by Capital Economics for the Financial Times found that Italy, Spain, Portugal and Greece collectively added more than €200bn of GDP over the past six years, while Germany’s GDP expanded by a relatively small €85bn. According to the OECD, growth in northern European economies is expected to stagnate over the year ahead, while southern European countries are forecast to grow at a much faster rate, as the table below shows. 

A decade after the debt crisis, fortunes have reversed when it comes to government borrowing, too. According to OECD forecasts, the debt to GDP ratio will rise in France and Belgium over the next two years, but decline significantly in Portugal and Greece. Thanks to this two-speed economy, the gap between 10-year bond yields in Italy and Germany (a gauge of what it costs the two countries to borrow) has shrunk to one of the lowest levels since 2021. This spread currently stands at around 127 basis points (bps), down from over 300 bps in 2018 and over 500 at the end of 2011. 

In the US, things are different again. Inflation is taking a meandering path back to target, with rate-setters yet to get the “greater confidence” that they need to cut rates. This isn’t an entirely bad thing: according to Fed chair Jerome Powell, the US economy has “the luxury of having strong growth and a strong labour market, very low unemployment, [and] high job creation”. 

The latest OECD forecasts imply that the US economy will expand by 2.6 per cent this year, and 1.8 per cent in 2025. Crucially, International Monetary Fund (IMF) economists also judge that the US economy is working above full capacity, running a ‘positive output gap’. For much of northern Europe – including the UK – this gap is firmly negative. 

You might be wondering where the UK economy fits in, and markets seem to be grappling with the same question. In February, markets were pricing in seven-and-a-half 25 bps rate cuts by the end of next year. By April, investors expected just four. Economists at Pantheon Macroeconomics noted that although UK data had proved surprisingly strong, it was “not enough to warrant” the change in market expectations. 

Why the pessimism? One view is that the UK is a transatlantic economy, beset by a combination of American and European problems. In an April Financial Times article, Bank of England (BoE) rate-setter Megan Greene said that inflation persistence was a greater threat in the UK than the US, thanks to the “double whammy” of a US-style tight labour market and European energy price shock. She warned that inflation could linger for longer here than in the US, warning that “rate cuts in the UK should still be a way off”. Tellingly, the OECD expects the UK to suffer the stickiest inflation in the bloc this year. 

Yet an optimist might argue that because the UK’s inflation surge was energy price driven, it should more rapidly abate this year. Crucially, not everyone shares the OECD’s gloomy outlook, and forecasts from consultancy Capital Economics see inflation falling to 0.8 per cent by the end of the year. BoE governor Andrew Bailey has also stressed that inflation dynamics in the US are more “demand led”, less of a problem here given that the OECD expects just 0.4 per cent growth in 2024. 

This all means that, as the dust settles, we should be wary of comparisons between the UK and other economies. Big economic shocks are giving way to more subtle economic differences. These might not grab our attention in the same way – but they still deserve to do so.