Smaller-than-expected decline in UK GDP boosts case for more interest rate hikes

The UK economy is estimated to have contracted by 0.1% in May compared to April, surprising consensus expectations to the upside. The economy was expected to contract by 0.3% as there was an additional bank holiday across the country to mark the coronation of King Charles III.

Past additional bank holidays have typically resulted in larger falls in activity, followed by a rebound in the following month. For example, the Platinum Jubilee bank holiday in June 2022 and the bank holiday to mark the day of national mourning following the passing of Queen Elizabeth II in September 2022 both contributed to GDP falling by 0.7% in those months.

And so the smaller contraction on this occasion either suggests that the underlying momentum in the economy was stronger than thought, or that the bank holiday (and celebrations) disrupted activity by less than past examples. The size of the rebound in the next reading will give us a better understanding of the impact from the bank holiday.

Within the details of the release, services activity was flat largely thanks to a 1.1% rise in activity in human health and social work activities, which also made the largest positive contribution in the month.  Arts, entertainment and recreation, along with education and information and communications sectors also made positive, albeit smaller contributions in May.

However, these were offset with a 0.5% decline in wholesale, retail and repairs activity, along with administrative support sectors, accommodation and food services sectors and the financial and insurance sectors.

Outside of services, both manufacturing output and wider industrial production contracted in May, while construction activity also fell.

Overall, while the headline numbers suggest a poor reading for the economy, the small contraction compared to past declines when additional bank holidays have taken place means that the economy has outperformed expectations.

The figures also suggest that the Bank of England can, and perhaps should, keep raising interest rates in coming months. We recently raised our forecast for interest rates to reach 6.5% for the end of this year, which remains an above consensus call (see UK should brace for 6.5% interest rates: here's why we’ve raised our forecast).

However, financial markets are slowly starting to agree, with options markets now pricing in a peak of 6.25% (see charts, below), helping to lift sterling significantly in recent days.

_{Source: Refinitiv, Eikon, GS (OIS data taken 12 July).  Schroders Economics Group. 13 July 2023.}