The chancellor will on Wednesday declare that the UK’s low growth “is not our destiny” in a speech pledging to bolster the country’s economic potential. 

Rachel Reeves’ initiatives will include a scheme to better link the high-productivity areas of Oxford and Cambridge, alongside plans for new rail projects and reservoirs. 

But the backdrop to her speech is a decidedly gloomy one, after the economy flatlined in the second half of 2024 and business confidence ebbed in the wake of tax hikes in October’s Budget. 

What has been ailing the UK economy since the election?

The UK is estimated to have failed to grow in the second half of last year, after a relatively strong start to 2024. Output is likely to undershoot the Office for Budget Responsibility’s outlook for 2025 as well, with the IMF predicting an expansion of 1.6 per cent in its latest outlook. 

One of the factors dragging on growth was the UK’s “very poor international trade performance”, said Andrew Wishart, economist at Berenberg, with total exports falling while they held steady in other major economies. The UK’s high production costs weighed on the export sector, he added, as companies face some of the highest electricity costs in the developed world alongside unusually big increases in labour costs. 

At the same time, the leading services sector stopped contributing to overall growth. Services lifted growth at the start of 2024, with an expansion of 0.9 per cent in the first quarter, but registered no growth in the three months to September and the three months to November, the latest available data. 

Alan Taylor, a member of the Bank of England’s monetary policy committee, has warned of “ebbing confidence” due to a “cash flow squeeze” being felt by both businesses and households, in the form of tax hikes and continued high mortgage costs.

What was the impact of Labour’s first Budget? 

Business groups say that elements of Labour’s Budget in October made this uninspiring picture worse. 

Reeves’ decision to raise £25bn via an increase in employer national insurance contributions, coupled with a sharp increase in the national living wage, has added to employment costs and dragged sharply on business sentiment. 

There are increasing signs that businesses will shed staff as they attempt to keep costs under control. The S&P Global flash purchasing managers’ survey last Friday showed the net share of businesses reducing staff numbers in January and December was the highest since the global financial crisis in 2009, apart from the start of the pandemic in 2020. 

Sushil Wadhwani, a former Bank of England rate-setter, said Reeves had “lost the growth narrative” partly as a result of the tax hike on businesses, adding that the decision had also muddied the labour market outlook for the BoE as it weighs how rapidly to cut interest rates. 

“This is a lot about animal spirits, and she damaged animal spirits,” said Wadhwani. 

What are the longer-term problems?

All this comes in the context of a weak longer-term picture in the UK, in particular moribund productivity. Output per hour worked for April to June 2024 decreased by 0.9 per cent compared with the same quarter a year ago, according to the ONS. 

Compared with Q4 2019, before the pandemic, output per hour worked rose only by 0.8 per cent, according to the latest figures, well below the 2 per cent previously estimated. This is particularly weak compared with the US where labour productivity rose by 8.3 per cent over the same period, buoyed by factors including strong corporate investment and a booming tech sector. 

Business investment has been lacklustre, particularly during a long period of stagnation following the Brexit referendum in 2016. 

In the three months to September 2024, business investment was up 5.7 per cent compared with the same period the previous year, according to official data. But it was up by the same amount in the eight years since early 2016, reflecting the lack of growth after the vote to leave the EU and the contraction during the pandemic. 

This is a much weaker rate than in the US, where private non-residential fixed investment has risen by 40 per cent since 2016. And in the eight before the Brexit referendum, UK business investment rose by about 26 per cent. 

How will Reeves try to change the narrative?

Reeves has been pledging radical changes to the UK’s planning system to unlock more infrastructure projects and housebuilding, as well as reforms to better tap into pension savings.

She has been signalling her support for a third runway at Heathrow airport to boost connectivity, alongside support for a so-called Oxford-Cambridge Arc that would bolster output in the science-rich region. 

An industrial strategy focusing on key sectors including advanced manufacturing, creative industries such as film and TV, and financial services will follow in the spring.

With Donald Trump vowing to slash regulation in the US, the UK government has also been promising business it will hack away at red tape including easing constraints on mortgage lending and a change of leadership at the competition regulator. 

A new National Infrastructure and Service Transformation Authority has been announced to get to grips with endemic project delays.  

Jim O’Neill, a former Treasury minister and Goldman Sachs economist, said it was critical for the chancellor to convince the private sector that the UK’s trend rate of growth can be lifted, and that meant explaining the value of her strategy to boost investment. 

The poor growth rate reflects weak investment and productivity, said O’Neill. “Her framework in principle is designed to deal with that but they have to be serious about it and make sure anyone who will be a co-investor believes it.”   

Will it work? 

Wadhwani said he doubted the short-term picture would improve unless Reeves “breaks the expectation” that taxes will have to go up again given the weak state of the public finances.

Progress in lowering barriers to trade with the EU, the UK’s biggest market, would deliver a positive jolt to sentiment, he added. 

Michael Saunders, of Oxford Economics, said many of Reeves’ policies on public and private investment made sense, but did not go far enough. The government needed to focus on bolstering investment in intangible assets, not just physical ones, he said.

And it was likely to run up against shortages of construction workers given the breadth of its infrastructure and housing ambitions, he added, which meant devising a convincing labour force development plan

“A broader strategy for potential growth is needed,” he said. That means “making the case for supply-side policies that pay off over 10 to 20 years”.

Data visualisation by Keith Fray