U.K. rebounds as consumers splurge, factories rev up

• U.K. retail sales, manufacturing activity, and the services sector show strong growth.
• The Bank of England signals greater willingness to raise interest rates to tame inflation.
• Tensions rise between the U.K. and the EU over goods and border control in Northern Ireland.

In the United Kingdom, it is truly a reopening story. The economy is showing signs of stronger growth as consumers spend, factories ramp up production, and services rebound — all driven by the easing of lockdown rules and vaccinations.

An upswing as consumers splurge

The sectors that were expected to do well with reopenings have been booming. Retail sales surged in April. Online sales rose, but food purchases declined as people started to dine out. Since the United Kingdom did not have waves of fiscal stimulus, real retail sales did not have unusual bumps during the pandemic. Sales moved in line with the mobility restrictions.

In May, the purchasing managers' index (PMI) for manufacturing and services was a bit of a surprise. A deluge of new orders, along with global supply issues, helped to drive a record increase in manufacturing, which outperformed the services sector. The IHS Markit/CIPS UK Manufacturing PMI rose to 65.6 in May from 60.9 in April. The sector's employment growth also picked up. While activity in Britain's service industries grew last month, the increase was less than expected due to the gradual approach to reopenings. The sector might have been affected more than manufacturing by the different stages of reopenings. The IHS Markit/CIPS UK Services PMI rose to 62.9 in May from 61.0 in April.

The fourth and final stage of easing lockdown restrictions is still ahead. In mid-June, Prime Minister Boris Johnson delayed a much-awaited end to Covid-19 restrictions by about one month to July 19. The curbs were due to be lifted on June 21. The pause comes amid rising cases, driven by the more transmissible Delta variant, which was first identified in India.

Central bank may turn hawkish on rates

The Bank of England (BoE) has signaled a more hawkish tone on interest rates. The BoE's deputy governors Dave Ramsden and Jon Cunliffe warned against the record increase in home price inflation. Ramsden said there is a risk that demand increases before supply is available, which could lead to a more generalized pickup in inflationary pressures. Cunliffe was also worried about the rise in personal debt. But Gertjan Vlieghe, the most dovish member of the central bank's Monetary Policy Committee, said the central bank is more likely to wait until later in 2022 to raise rates.

The BoE has indicated that rate increases are going to be their first choice when it comes to tightening monetary policy. A key uncertainty for the United Kingdom is the post-furlough labor market. It is not clear how the labor market and economic activity will transition from the furloughs. Even if there is policy tightening, hiccups in the labor market could prevent a rapid pace of rate hikes.

Politics in Northern Ireland

Tensions between the United Kingdom and the European Union have escalated over the implementation of the Northern Ireland Protocol (NIP). In March, the U.K. unilaterally extended the grace period governing checks on certain goods; the EU called it a breach of international law. Negotiations have been held between both parties since the U.K. delivered a road map outlining the implementation of the NIP.

Northern Ireland politics seems to be complicating matters. The new leader of the Democratic Unionist Party (DUP) has argued the NIP is damaging the economy and needs to be removed. Political unrest in Northern Ireland has worsened since the start of this year, and there is resentment toward the NIP's full implementation. Given the rising tensions in Northern Ireland, the EU may be willing to compromise, but this is unlikely to be a smooth process.

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