The UK’s economic recovery from the COVID-19 pandemic has so far proven to be rapid but incomplete, and remains distorted by sectoral and regional imbalances. Over the winter, we expect a combination of persistent public health problems, revenue losses and supply degradations to result in a further slowdown in growth momentum. A lasting and complete recovery remains, in our view, far from assured. Much will depend on the labor market. In this chapter, we assess the outlook for the UK economy and the (many) challenges ahead.

A deep economic adjustment is now looming. Many changes in household consumption patterns during the pandemic appear to be increasingly persistent, and many businesses now appear to be expecting and preparing for a different economy in the years to come. Brexit compounds this challenge: Early evidence points to the start of a period of acute structural change in UK trade.
Inflation is expected to rise sharply in the second half of 2021, with the annual CPI expected to peak at 4.6% in April 2022. But the acceleration in inflation is currently due to a handful of mainly imported goods, services inflation. , in particular, more subdued. The risks of a more persistent domestic price spike appear to be contained for now, but inflation expectations are cause for concern. Overall, however, we believe that inflationary pressures should ease and that monetary and fiscal policies should, for now, continue to support the recovery.

Figure 1. Real gross domestic product (GDP), 2008–25

Notes and sources: see figure 2.1 of the IFS 2021 green budget.

Main conclusions

  1. The UK economy is in the midst of a sharp, but incomplete and extremely unbalanced recovery. Better public health prospects, easing restrictions and expanding budget support have all underpinned faster economic reopening in recent months than expected earlier this year. However, the UK economy still remains a major recession below its pre-COVID trajectory. The rebound also remains narrow in terms of composition – and distorted by sectoral and regional imbalances: demand exceeds supply in some (widely publicized) areas of the economy, but lags behind in many others.
  2. From there, we expect the accumulated household savings to provide only a limited boost to growth. As government support is reduced, businesses and households will also feel the income effects of insufficient activity for the first time as a whole. We are waiting a combination of persistent public health problems, revenue losses and supply degradations, all to cause growth dynamics to weaken further over the winter. In our opinion, a sustained and complete economic recovery is far from assured.
  3. A deep economic adjustment is looming. Economic activity during the pandemic was characterized by startling asymmetries. While some of these effects have abated as the economy reopens, many appear to be increasingly persistent. Household consumption remains, for example, down by 10% in social categories. Transportation and storage companies expect sales to be around 5% higher in the long run due to the pandemic, but hotel companies expect sales to be 4% lower. Many companies now seem to be expecting and preparing for a different economy in the years to come., indicating a long period of reconfiguration.
  4. Brexit will compound the challenge. The adjustment before 2020 appears to have been postponed due to continued access to the EU market and the weakness of the pound sterling. New frictions have added to the supply disruptions in recent months. Early evidence also points to the start of a period of acute structural change in British commerce. Among the goods, we expect the removal of suppliers and customers from the EU to accelerate. Services remain a more notable concern. Exports of professional services to the EU have been particularly lagging in recent years: exports of professional services to the EU were around 30% of the total in the first quarter of 2021 compared to 44% in the first quarter of 2016 We expect that these effects worsen in the years to come, which means a likely net decline in overall UK services exports.
  5. The labor market is the keystone of the recovery. While demand has already strongly reconfigured during the pandemic, budget support has prevented similar adjustments in the labor market. Sales have moved from sector to sector at a much faster rate than employment, with a cumulative reallocation of surplus jobs since the second quarter of 2020 of 24% below the equivalent figure for sales. The result was an increasingly “twisted” recovery. From there, we expect some of those pressures will start to ease off. The vacancies are expected to be reduced as the hires associated with the economic reopening are terminated. Adjustment is now expected to accelerate, with the end of holidays and the easing of uncertainties facilitating a wider recovery in labor mobility. Our forecasts see Unemployment rises to 5.5% in the first quarter of 2022 as holidays end and more returns to the labor market. This may only slowly fall back in the coming years with matching issues, a capital-intensive recovery and an increase in the effective tax burden on labor from next April, all likely to mean the market labor is lagging behind rather than leading the recovery.
  6. Recent wage growth has mainly reflected sector labor shortages rather than wage pressures across the economy. Record demand in sectors such as transport and food processing has resulted in well double-digit sectoral wage settlements. However, overall wage settlements remain broadly in line with their pre-pandemic range. For now, we continue to believe that some of these pockets of upward pressure will subside as supply improves, but a relative upgrading of skills now seems likely. Given that production is expected to remain behind the pre-pandemic growth path, we might expect another labor market slowdown and lower wages to emerge in the coming years. We expect real household disposable income growth to decline 0.1% in 2022-2023 as the cost of living increases.
  7. Inflation is expected to rise sharply in the second half of 2021, with an annual CPI forecast to peak at 4.6% in April 2022. For now, the pilots here seem transient. Energy and base effects are expected to drive inflation up, as are trade disruptions and imported inflation. These effects might turn out to be sticky, but should eventually wear off. The biggest risk remains a more persistent domestic price surge. For now, the risks remain more contained here. The acceleration in inflation is currently being driven by a handful of mainly imported goods, with services inflation, in particular, more subdued. We also don’t expect the labor market to be tight enough overall to push costs up any more persistently. Rather, high unit labor costs seem to lead to job losses rather than wage pressures.
  8. However, inflation expectations are more worrying. If these start to rise, firms may be willing to accept higher wages and offer higher prices, thus creating the potential for a real wage-price spiral. At the start of the pandemic, inflation expectations were rather than below target levels, unlike the United States and the euro area. Upward pressures on businesses, households and financial markets are increasingly evident, and acute labor shortages could increase risks. However, as transient inflation is likely to give way to disinflation, upside risks in the coming months could also shift to the downside in the medium term. The latter could prove to be even more difficult to fight.
  9. With the economy likely to reconfigure itself over the next 18 months, the link between the speed and ultimate size of the recovery is stronger than normal. A faster recovery could see COVID-related scars (i.e. permanent economic damage from the pandemic) limited to just 1-1.5% of GDP, compared to 3% in the OBR scenario March 2021. Slower recovery could mean larger hysteresis effects and larger permanent losses. We believe Brexit will continue to weigh on British capabilities. Combined with our assessment of the impacts of COVID-19, this means that we expect the economy to be 2½% smaller in 2024-25 than the OBR pre-pandemic forecast (March 2020).
  10. Continued political support may still be needed to ensure a full economic recovery. A simultaneous recovery in both supply and demand provides a basis for policy to “relax”. In this environment, supply is likely to be more sensitive to demand conditions than normal, which means the capacity is probably a bit higher than the official data might suggest. Stopping the momentum of recovery could also lead to a greater permanent loss of production, given the stronger link between scarring and speed of recovery. In the short term, higher inflation expectations create a risk that could subsequently require concrete measures to contain it. But, for now, we think politics should err on the side of support rather than less.
  11. As the room for maneuver in monetary policy is also severely limited, policy now needs to provide for fiscal capacity to play a greater role in macroeconomic stabilization. This is probably the key if politics are to be able to respond effectively to future crises.


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