A faster and fuller recovery within sight - Capital Economics
UK Economics

A faster and fuller recovery within sight

UK Economic Outlook
Written by Paul Dales
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Our view that the economy will return to its pre-pandemic size in Q1 2022 and that it won’t be permanently smaller due to the pandemic is a more optimistic take than that of most forecasters. It implies that the government doesn’t need to tighten fiscal policy to reduce the budget deficit from 20% of GDP in 2020/21 back to pre-pandemic levels of around 2% of GDP and that the Bank of England won’t need to launch more QE or resort to negative interest rates this year or next. The latter is consistent with market interest rate expectations and gilt yields rising this year.

  • Overview – Our view that the economy will return to its pre-pandemic size in Q1 2022 and that it won’t be permanently smaller due to the pandemic is a more optimistic take than that of most forecasters. It implies that the government doesn’t need to tighten fiscal policy to reduce the budget deficit from 20% of GDP in 2020/21 back to pre-pandemic levels of around 2% of GDP and that the Bank of England won’t need to launch more QE or resort to negative interest rates this year or next. The latter is consistent with market interest rate expectations and gilt yields rising this year.
  • Forecasts – Our forecasts assume that the severe COVID-19 restrictions remain in place in January, February and March, that they are eased only gradually in April, May and June, but that a rapid rollout of COVID-19 vaccines means few restrictions are required beyond June.
  • Consumer Spending – Households will lead the recovery as vaccines allow a boom in spending in pubs, restaurants, hotels and on holidays funded by the large stock of savings built up during lockdowns.
  • Investment – Businesses will be late to the party as the spare capacity generated by the crisis has reduced the need to invest and the increase in business debt has curtailed the ability to invest.
  • External Demand – A strong recovery in domestic demand will probably mean that imports rebound by more than exports and that the current account deficit widens back to levels seen before the pandemic.
  • Labour Market – It would be a huge success if, as we expect, the furlough scheme meant that after a 25% peak-to-trough decline in GDP during 2020, the unemployment rate peaks at only 6.5% later this year.
  • Inflation – The unwinding of the previous drags from petrol prices and the temporary VAT cut means CPI inflation will probably rise to just above 2% late this year. But we suspect it will drop below 2% in 2022.
  • Monetary & Fiscal Policy – Tightening fiscal policy in the next couple of years isn’t just unnecessary, but it would also limit the ability of the economic recovery to reduce the budget deficit over the next few years.
  • Long-term Outlook – Beyond the next couple of years, the legacy of the COVID-19 crisis is unlikely to be a permanently smaller economy and may be higher inflation and bigger public deficits.

Key Forecasts Table

Table 1: Key Forecasts*

2019

2020

2021

Annual (% y/y)

Q4

Q1

Q2

Q3

Q4f

Q1f

Q2f

Q3f

Q4f

Average 2010-18

2019

2020f

2021f

2022f

Demand (% q/q)

GDP

0.0

-3.0

-18.8

16.0

0.6

-1.5

3.0

4.0

1.5

1.9

1.4

-10.0

5.5

6.5

Consumer Spending

-0.3

-3.0

-22.2

19.5

0.8

-1.5

4.0

4.5

2.5

1.9

1.1

-11.7

7.5

8.8

Government Consumption

0.0

-3.4

-14.5

10.4

5.0

-2.0

7.7

6.4

-1.2

0.9

4.0

-8.4

11.5

2.0

Fixed Investment

-1.6

-0.9

-22.8

17.9

1.2

-2.2

1.2

4.6

2.9

3.2

1.5

-11.5

4.0

11.0

Business Investment

-0.2

-0.7

-25.4

9.4

-0.5

-4.0

5.0

7.0

4.0

3.9

1.1

-15.8

0.3

16.0

Stockbuilding1 (contribution, ppts)

-0.1

0.7

-0.5

1.5

0.5

-1.2

-0.7

0.2

0.2

0.2

0.1

0.5

-0.7

0.0

Domestic Demand2

-2.0

-0.8

-22.2

20.4

2.2

-2.9

3.5

5.1

2.0

2.0

1.6

-11.2

7.2

8.0

Exports

3.8

-13.1

-8.6

-0.4

7.2

-3.0

4.0

3.0

2.5

3.2

2.7

-13.0

5.0

8.7

Imports

-3.1

-7.0

-20.8

11.7

13.1

-7.4

6.0

7.0

4.0

3.6

2.7

-17.9

10.2

13.5

Net Trade2 (contribution, ppts)

2.2

-2.1

3.7

-3.5

-1.6

1.4

-0.6

-1.2

-0.5

-0.2

-0.1

1.8

-1.5

-1.5

Labour Market (% q/q)

 

 

 

 

 

 

Unemployment (ILO measure, %)

3.8

4.0

4.1

4.8

5.2

5.5

5.9

6.2

6.5

6.3

3.8

4.5

6.0

5.5

Employment

0.6

0.2

-1.0

-0.5

0.1

-0.5

-0.6

-0.1

0.7

1.2

1.1

-0.4

-1.3

2.0

Total Hours Worked

-0.1

-3.8

-15.4

8.1

0.5

-1.2

2.4

3.2

1.1

1.4

1.4

-11.6

2.5

5.0

Productivity (output per hour)

0.1

0.8

-4.0

7.3

0.1

-0.3

0.5

0.7

0.4

0.5

0.0

1.7

3.2

1.5

Income & Saving (%q/q)

 

 

 

 

 

 

Nominal Average Weekly Earnings3

0.4

0.0

-2.6

3.7

1.7

0.0

1.5

0.4

0.3

2.0

3.5

1.4

4.0

1.7

Real Average Weekly Earnings4

0.2

0.0

-2.6

3.3

1.7

0.2

0.3

-0.1

-0.2

-0.2

1.6

0.5

2.5

0.0

Real Household Disposable Income

1.6

-1.0

-2.9

4.9

1.5

-1.4

1.6

-0.2

-0.5

1.7

1.9

0.8

2.5

1.2

Saving Ratio (%)

7.7

9.5

27.4

16.9

18.0

18.1

16.3

12.4

9.9

8.4

6.8

18.0

14.2

7.8

Prices (% y/y)

 

 

 

 

 

 

CPI

1.4

1.7

0.6

0.6

0.5

0.2

1.4

1.5

2.0

2.3

1.8

0.8

1.3

1.7

Core CPI5

1.6

1.6

1.4

1.3

1.2

0.8

1.3

1.4

1.6

2.1

1.7

1.4

1.3

1.6

CPIH

1.4

1.7

0.8

0.8

0.7

0.4

1.3

1.4

1.7

2.1

1.7

1.0

1.2

1.5

RPI

2.2

2.6

1.2

1.1

1.2

1.2

2.5

2.4

2.7

3.1

2.6

1.5

2.2

2.2

RPIX

2.2

2.7

1.4

1.3

1.4

1.4

2.5

2.4

2.5

3.2

2.6

1.7

2.2

2.1

Nationwide House Prices (end period)

0.8

2.3

1.9

3.4

6.5

6.4

3.7

-1.3

-5.0

3.6

0.8

6.5

-5.0

2.0

Monetary Indicators (end period)

 

 

 

 

 

 

Bank Rate (%)

0.75

0.75

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.48

0.75

0.10

0.10

0.10

Announced BoE QE (£bn)

435

645

745

745

895

895

895

895

895

351

435

895

895

895

10-Year Gilt Yield (%)

0.74

0.39

0.18

0.25

0.39

0.36

0.41

0.45

0.50

2.06

0.74

0.39

0.50

0.50

Sterling Trade-weighted Index

80.8

78.1

76.6

77.0

78.8

79.2

79.2

79.2

79.1

82.3

80.8

78.8

79.1

79.8

$/£

1.33

1.24

1.25

1.29

1.37

1.38

1.39

1.39

1.40

1.49

1.33

1.37

1.40

1.45

Euro/£

1.18

1.14

1.11

1.10

1.12

1.12

1.12

1.12

1.12

1.21

1.18

1.12

1.12

1.12

Current Account & Public Finances

 

 

 

 

 

 

Current Account (£bn)

2

-19

-12

-16

-21

-14

-17

-22

-24

-45

-69

-67

-77

-95

% of GDP

0.3

-3.4

-2.5

-2.9

-3.8

-2.6

-3.1

-4.0

-4.2

-2.9

-3.1

-3.2

-3.5

-4.0

PSNB6 (£bn, financial year)

91

56

410

160

80

% of GDP (financial year)

5.0

2.5

19.6

7.1

3.3

Global (% y/y)

 

 

 

 

 

 

World GDP7(CE estimate for China)

2.6

-2.7

-9.4

-2.4

-1.3

3.9

12.6

5.6

5.1

3.7

2.6

-4.0

6.8

4.8

Oil Price (Brent, $pb, end period)

66

23

41

41

52

53

55

57

60

80

66

52

60

55

Sources: Refinitiv, Capital Economics; 1Excluding alignment adjustment; 2Including valuables; 3Including bonuses; 4Earnings deflated by CPI; 5Excluding energy, food, alcohol & tobacco; 6Excluding banking groups; 7PPP terms

* Assumes that the severe COVID-19 restrictions remain in place in January, February and March, that they are eased only gradually in April, May and June, but that a rapid rollout of COVID-19 vaccines means few restrictions are required beyond June.


Overview

A rapid rebound around the corner

  • We are more optimistic than most by expecting COVID-19 vaccines to allow the economy to surge back to its pre-crisis peak by Q1 2022 and to its pre-crisis trend in 2025. As a result, the budget deficit should shrink back to 2% of GDP without the need for major tax hikes. And the Bank of England won’t need to expand QE or use negative interest rates in 2021 or 2022.
  • We suspect that January’s third COVID-19 lockdown will leave GDP about 10% below its pre-crisis peak. (See Chart 1.) But if the promising start to the rollout of vaccines is maintained, then at least some easing in COVID-19 restrictions in Q2 and a major easing after June should allow GDP to start rebounding rapidly in Q2 and Q3.
  • With households having built their up savings during the crisis while firms had to load up on debt to survive, consumer spending is much better placed to rebound than business investment. And given that real GDP in the UK fell further than in the euro-zone, the bounce back in the UK is likely to be a bit bigger. But the UK will continue to lag behind the US. (See Chart 2.)
  • Our view that people will quickly go back to the pubs/restaurants and that the economy’s supply potential won’t be permanently damaged by the crisis explains why, unlike most forecasters, we think that by 2025 GDP will be back to where it would have been had COVID-19 never existed. (See Chart 3.)
  • Of course, the path to that point won’t be smooth. The scheduled expiry of the furlough scheme at the end of April may mean that the 1.4% fall in employment seen so far will turn into a 3.0% fall by the end of the year. But it would be a huge success if the furlough scheme meant that the 25% peak-to-trough fall in GDP during last year led to the unemployment rate peaking at only 6.5% later this year and falling back to 5.0% by the end of 2022. (See Chart 4.)
  • This has come at a huge fiscal cost with the government’s direct support for the economy so far costing £285bn (14% of GDP). After pencilling in an extra £15bn of spending this year and adding in the indirect effects of the weak economy, the budget deficit in 2020/21 may be about £410bn (19.6% of GDP).
  • If we are right in expecting GDP to regain its pre-crisis trend, then the resulting rise in tax revenues and fall in spending means the budget deficit will drop back to 2% of GDP without the need for major tax hikes. (See Chart 5.)
  • While there is a growing risk of a sustained rise in inflation once the economy has fully recovered, over the next couple of years the large amount of spare capacity means that inflation will probably spend more time below the 2% target than above it. (See Chart 6.)
  • This may prompt the Bank of England to complete the extra £150bn of QE announced in November over six months rather than most of this year. (See Chart 7.)
  • But as financial firms are not yet able to implement negative rates, and the economy will be recovering by the time they are (perhaps around the middle of the year), we think the markets are wrong to price in negative interest rates this year and next. (See Chart 8.) As such, 10-year gilt yields may yet rise a bit further from 0.30% now to 0.50% by the end of this year.

Overview Charts

Chart 1: Monthly Real GDP (February 2020 = 100)

Chart 2: Quarterly Real GDP (Q4 2019 = 100)

Chart 3: Quarterly Real GDP (Q4 2019 = 100)

Chart 4: ILO Unemployment Rate (%)

Chart 5: Public Sector Net Borrowing (As a % of GDP)

Chart 6: CPI Inflation (%)

Chart 7: Bank of England Quantitative Easing (£bn)

Chart 8: Bank Rate Expectations (%)

Sources: Refinitiv, OBR, Bank of England, Capital Economics


Consumer Spending

Consumers to quickly ramp up spending once restrictions are eased

  • The surge in household savings means that consumers are in a much better position than businesses to quickly ramp up spending once the COVID-19 restrictions are lifted.
  • Retail sales have been one bright spot of the economy since the start of the pandemic. Even after the second COVID-19 lockdown in November, they were still up by 2.4% y/y due to booming online sales. (See Chart 9.)
  • However, the strength in retail sales is because some spending has shifted away from hospitality and leisure services, which have been closed during lockdown, and towards goods which can be bought online (i.e. going out for fewer meals but buying more cushions!). But as goods aren’t a perfect substitute for services, total consumer spending still probably fell by almost 12% in 2020. (See Chart 10.)
  • Thanks to the unprecedented government support, which has focused on household incomes, nominal average earnings probably rose by 1.4% in 2020. Rising nominal incomes and a sharp fall in spending meant that household savings soared. The saving ratio peaked at 27.4% in Q2 2020 and due to the third lockdown may still be almost 20% in Q1 2021. (See Chart 11.)
  • That’s equivalent to households saving about £300bn in the year to Q1 2021, compared to £100bn in 2019. Indeed, the amount of cash households are holding in their bank accounts has risen by more than £120bn since February. (See Chart 12.) If households spent all that £120bn, it could boost GDP by around 6%.
  • Of course, not all households have been able to add to their savings. Job losses have been concentrated in the lowest-paid sectors, such as restaurant and events. Since low-income households tend to spend a higher share of their income, higher debt levels amongst low income households may mean that consumption doesn’t rebound as much as savings imply. However, on aggregate at least, consumers’ balance sheets are looking healthier than before the crisis.
  • What’s more, as employees come off the furlough scheme, most will return to their previous jobs and their previous salaries. The rise in real wages of those who remain in employment may offset the drag on real incomes from the fall in employment in 2021. (See Chart 13.) This will flip in 2022 as strong growth in employment outweighs weak real wages. The upshot is that real household disposable incomes could rise by 2.5% in 2021 and by about 1.2% in 2022.
  • Overall, households are in a good position to quickly ramp up spending on services once COVID-19 restrictions are eased. Admittedly, this will be partly offset by less spending on goods, so retail sales growth may tail off. This will especially be the case if the mini-boom in the housing market runs out of steam later this year when the stamp duty cut expires on 31st March. (See Chart 14.)
  • But overall consumer spending will still lead the recovery and be back to its pre-crisis level in early 2022. (See Chart 15.) This would be a much stronger rebound than the one we expect for business investment. (See Chart 16.)

Consumer Spending Charts

Chart 9: Retail Sales (February 2020 = 100)

Chart 10: Consumer Spending (Q4 2019 = 100)

Chart 11: H’hold Saving Ratio (% of Disposable Income)

Chart 12: Households Cash Holdings (M4ex., £bn, m/m)

Chart 13: Contributions to Real Household Disposable Income Growth (ppts)

Chart 14: Housing Transactions & Spending on Household Goods (% y/y)

Chart 15: Consumer Spending Growth

Chart 16: GDP Components (Q4 2019 = 100)

Sources: Refinitiv, Capital Economics


Investment

Firms to stay focused on survival not expansion for a while yet

  • Business investment is likely to be held back by huge spare capacity and high debt burdens. However, the mini-boom in the housing market and efforts by the government to raise public capital spending mean that government and residential investment will remain strong over the next few years.
  • The release of pent-up demand and the stamp duty holiday have spurred housing demand and mean that residential investment has already regained its pre-crisis level. Admittedly, the expiry of the stamp duty holiday on 31st March may cause dwelling investment to contract by about 5% q/q in Q2. But we expect the fall in demand for office space to be partly offset by a rise in demand for residential space, resulting in residential investment rising by 2% q/q over the next few years. That’s double the pre-crisis 10-year average of 0.9% q/q. (See Chart 17.)
  • What’s more, in the Spending Review on 25th November the government committed to raising capital investment over the next few years as part of its aim to “level up” the regions. As a result, we expect growth in government investment to rise from just 0.2% in 2020 to 3.4% in 2021 and to 7.0% in 2022. This means that government investment will significantly outperform the broader economy over the next few years. (See Chart 18.)
  • Business investment, on the other hand, will take much longer than other parts of the economy to recover for three key reasons. First, firms’ profits have dropped sharply as a result of the crisis, which will reduce available funds for investment. (See Chart 19.) And non-financial firms took on an additional £116bn of debt in 2020, compared to an additional £7bn in 2019. That’s equivalent to about half of all business investment in 2019. If firms were to pay back all this debt over ten years, it could reduce the funds available for investment by about £10bn a year (5% of 2019 business investment.)
  • Smaller firms may be especially concerned about access to credit if the Coronavirus Business Interruption and Bounce Back loan schemes end as scheduled on 31st March. Indeed, in the second half of last year it was primarily smaller firms borrowing more as larger firms paid back bank debt. (See Chart 20.) And many firms are going to have to start paying interest and making repayments on these loans from March.
  • Second, many firms will not need to invest. Businesses were still operating at well below normal capacity rates late last year. (See Chart 21.) As such, a large amount of spare capacity in the economy will persist for several years.
  • Third, for a couple of years there will be at least some uncertainty about demand. Admittedly, the Brexit deal signed on Christmas Eve last year has removed a major source of uncertainty for firms. But the pandemic has shifted some spending patterns and firms’ could be uncertain about demand for their products. Indeed, measures of firms’ investment intentions have remained subdued. (See Chart 22.) As a result, we expect business investment to lag behind total investment and GDP. (See Chart 23.)
  • Business investment will eventually recover, not least as the pandemic will prompt many businesses to spend more on their online and technology infrastructures. And the strength of government and residential investment means that total investment may not recover that much slower than consumer spending. (See Chart 24.)

Investment Charts

Chart 17: Housing Transactions & Dwellings Investment (% q/q)

Chart 18: Government Investment & GDP (Q4 2019 = 100)

Chart 19: Business Profits & Investment

Chart 20: Business Bank Loans (£bn, m/m)

Chart 21: Firms Working Below Capacity & Business Investment

Chart 22: CBI Investment Intentions & Business Investment

Chart 23: Investment & GDP (Q4 2019 = 100)

Chart 24: GDP (Q4 2019 = 100)

Sources: Refinitiv, Capital Economics


External Demand

UK no more dependent on rest of the world than before COVID or Brexit

  • COVID-19 and Brexit are unlikely to leave the UK any more dependent on the rest of the world than before. Indeed, we think net trade will remain a drag on GDP growth and that the current account deficit will widen back to around 4% of GDP in 2022.
  • Our view that most of the UK’s main trading partners will enjoy a fairly rapid recovery from the COVID-19 crisis suggests that the UK’s goods and services exports will rise back towards pre-pandemic levels over the next two years. (See Chart 25.)
  • That said, there are three reasons why the UK’s exports may be a bit slower to recover than overseas demand. First, the new procedures that came into force after the Brexit transition period ended at the turn of the year are causing some teething problems that will probably hold back exports in the first half of this year.
  • Second, while we don’t think that the absence from the Brexit deal of “equivalence” for financial services means London will no longer be a major financial centre, it does make sense that the UK’s financial services exports will grow at a slower pace. And trade in financial services explains about a third of the UK’s trade in services surplus. (See Chart 26.)
  • Third, avoiding a no deal Brexit has removed a major downside risk to the pound. And our view that the sterling trade-weighted index will edge up over the next two years will provide a small headwind to exports. (See Chart 27.)
  • At the same time, the strong recovery in domestic demand we envisage suggests that the UK’s goods and services imports will rise by more than exports. (See Chart 28.)
  • In particular, we suspect that people will start going on holiday soon, which would boost the UK’s travel imports relative to its travel exports. The current unusual trade in travel surplus would then revert to the normal deficit. (See Chart 29.)
  • As a result, we think that the trade surplus seen during the pandemic will be replaced in 2022 by a trade deficit of about 1.5% of GDP. (See Chart 30.) That would be consistent with net trade subtracting about 1.5 percentage points from real GDP growth in both 2021 and 2020.
  • The current account will probably move in the same direction as changes in the primary and secondary income deficits broadly offset each other. With the stock of UK assets held by foreigners having risen further above the stock of overseas assets held by the UK last year, it makes sense for the UK’s deficit in income flows (“primary income”) to increase.
  • Meanwhile, the cut in the UK’s foreign aid budget and, from 2022, its payments to the EU as part of the Brexit financial settlement mean the secondary income deficit should shrink.
  • All in, we expect the current account deficit to widen from just over 3.0% of GDP last year to around 3.5% in 2021 and to 4.0% in 2022. That would leave it pretty much at pre-COVID and pre-Brexit levels. (See Chart 31.)
  • This small move in the current account deficit will probably hide some big swings in funding. We suspect that the spike in net lending of households during the pandemic will be reversed a bit quicker than the surge in the net borrowing of the public sector. (See Chart 32.)

External Demand Charts

Chart 25: World GDP & UK Exports (Q1 2018 = 100)

Chart 26: Trade in Services Balance (As a % of GDP)

Chart 27: Sterling Trade-Weighted Index (2005 = 100)

Chart 28: Domestic Demand & Imports (Q4 2019 = 100)

Chart 29: Trade in Services Balance (As a % of GDP)

Chart 30: Trade in Goods & Services Balance

Chart 31: Current Account Balance (As a % of GDP)

Chart 32: Financial Balances (As a % of GDP)

Sources: Refinitiv, Capital Economics


Labour Market

Unemployment rate won’t stay high for long

  • Our forecast that the unemployment rate will peak at 6.5% at the end of 2021 would be a good result given the sheer size of the downturn in activity. And if we are right in thinking that the economy will escape the crisis without much long-term scarring, then by 2022 the unemployment rate will be well on the way to returning to its pre-pandemic level of 4.0%.
  • The impressively small fall in employment compared with the slump in GDP in 2020 is a testament to the success of the government’s furlough scheme. In October, the economy was 6.3% smaller than before the crisis and in Q3 the number of hours worked were down by 12%. By contrast, employment had fallen by just 1.4% since February.
  • The extension of the furlough scheme until the end of April should help to prevent further job losses. And if our assumption that many COVID-19 restrictions will stay in place until June proves correct, then there may be lingering policy support for jobs in May and June.
  • That said, the third lockdown from 5th January will surely take some toll on firms, even if the use of the furlough scheme surges. (See Chart 33.) And once the government’s support for the job market expires, employment will need to fall back in line with GDP. That’s why we expect the 1.4% fall in employment so far to turn into a 3.0% fall by July, a total decline of 1 million.
  • So the economy is still probably two quarters away from starting to generate any net gains in employment. Beyond July, employment should spring back in line with the recovery in activity, as the reopening of the economy allows demand for labour to recover. (See Chart 34.) That would be equivalent to average monthly gains in employment of about 70,000.
  • Meanwhile, we think unemployment will climb from 1.7m in October to 2.3m by December 2021. And we expect a rise in the jobless rate from 4.9% in October to a peak of about 6.5% by the end of 2021, before falling back to 5.0% by the end of 2022. (See Chart 35.)
  • But we suspect that the labour market recovery will be quicker than after previous recessions. (See Charts 36 & 37.) This is consistent with our view that the economy’s potential won’t be permanently damaged by the crisis.
  • Earnings growth has held up relatively well due to compositional effects as job losses have been disproportionally concentrated in relatively low-paying sectors and occupations. But our forecast that 6 million furloughed workers will face a 20% pay cut in January, up from 2.4 million at the end of October, is consistent with a 0.5% m/m hit to pay in January. (See Chart 38.)
  • Moreover, excess capacity will remain a feature of the labour market for a number of years. Our “broad unemployment rate”, which takes into account those who want a job, those who would like to work longer hours and those on the furlough scheme, suggests that there is as much spare capacity in the labour market now as if the actual unemployment rate were 9.0%. (See Chart 39.) That will weigh on wage growth and may mean that even in 2022, earnings may grow by less than 2.0%. (See Chart 40.)

Labour Market Charts

Chart 33: No. of People on Furlough Scheme (Millions)

Chart 34: Employment & GDP

Chart 35: ILO Unemployment Rate (%)

Chart 36: Change in ILO Unemployment Rate (ppts, Relative to Rate at End of Recession)

Chart 37: Change in Employment (ppts, Relative to Pre-Crisis Peak)

Chart 38: No of Jobs Furloughed & Average Earnings

Chart 39: Unemployment (% of Workforce)

Chart 40: Total Average Earnings (%3myy)

Sources: Refinitiv, ONS, UK Government, Capital Economics


Inflation

Inflation to rise above target temporarily

  • Higher commodity prices and the end of the VAT cut for the hospitality sector will probably push up CPI inflation to almost 2.5% in early 2022. But ample spare capacity means it will probably settle at close to 1.5% by the end of next year. Further ahead, inflation may creep higher if the authorities keep monetary and fiscal policy loose after all the spare capacity in the economy has been absorbed.
  • A rise in CPI inflation from 0.3% in November to almost 2.5% in late 2021 is already pretty much baked in the cake for three reasons. First, the GSCI Global Agricultural Price Index rose by almost 25% y/y in the first week of January. If food prices follow agricultural commodity prices higher, as they normally do, then this will add 0.4 percentage points (ppts) to inflation by the end of 2021. (See Chart 41.)
  • Second, oil prices have more than doubled since their low point in April 2020. This will add an additional 0.5ppts to inflation by the end of the year. (See Chart 42.) And the rise in wholesale energy prices from their summer lows makes it likely that Ofgem will raise its utility price cap at the next review in April.
  • Third, the declines in consumer prices triggered by the temporary VAT cut and the government’s Eat Out to Help Out restaurant scheme for the tourism/hospitality sectors will fall out of the annual comparison in April and September respectively. This will add another 0.6ppts.
  • However, once these commodity and tax effects have worked their way through the system, the large amount of spare capacity in the economy will probably mean that inflation starts to fall back in the first half of next year. (See Chart 43.)
  • Indeed, surveys suggest that the recent strength in core goods inflation, which has probably been driven by the lockdown-induced shift in demand from services to goods, is not set to last. (See Chart 44.)
  • Admittedly, there is some evidence that prices are rising in those areas that are experiencing supply constraints, such as second-hand cars and hairdressers. (See Chart 45.) But this should ease as lockdown restrictions are lifted in the spring and summer.
  • And, more importantly, large amounts of spare capacity are forcing businesses to focus on maintaining their customer base and capping other costs, such as wages. Our forecast that by 2022 earnings growth will be below 2% points to only a partial rebound in services inflation. (See Chart 46.)
  • Overall, we expect higher commodity prices and tax increases to push inflation to a peak of 2.5% in early 2022. But the effects of spare capacity will then mean it falls back and settles at about 1.5%.
  • Further ahead, once this spare capacity is used up, there is a risk that inflation will rise above the 2.0% target. That’s especially the case as, unlike after the GFC, the huge policy stimulus has worked its way into the hands of households and businesses who are more likely to spend it. (See Chart 47.)
  • But even if there is some incentive for the government to let inflation rise and keep interest rates low, the Bank of England is very unlikely to let inflation get out of control. And inflation expectations have not risen above pre-pandemic levels. (See Chart 48.) As such, any rise in inflation will be modest by historical standards.

Inflation Charts

Chart 41: Agricultural Commodity Prices & Food CPI

Chart 42: Oil Prices & CPI Fuel Price Inflation

Chart 43: CPI Inflation (%)

Chart 44: BRC Shop Price Index & Core Goods Inflation

Chart 45: Hairdressing & Used Car CPI Inflation (%)

Chart 46: Average Earnings & Core Services CPI Inflation

Chart 47: M4 Money Holdings (£bn)

Chart 48: Market Inflation Expectations (%)

Sources: Refinitiv, Capital Economics


Monetary & Fiscal Policy

No need to raise taxes when the economy will solve the fiscal problem

  • As a result of our view that the economy will escape the COVID-19 crisis without major long-term scarring, taxes won’t need to rise to fill a structural hole in the public finances. Meanwhile, we think the Bank of England won’t need to expand quantitative easing (QE) or use negative interest rates in 2021 or 2022.
  • Since the start of the pandemic, the government has announced direct support for the economy worth £285bn (14% of GDP). This puts the UK far ahead of most other European countries. (See Chart 49.) And for all the talk of possible tax rises in the Budget on 3rd March, we think the government is more likely to unveil extra fiscal stimulus. We have pencilled in an extra £15bn (0.7% of GDP) of spending in 2020/21 and £10bn (0.5% of GDP) in 2021/22 on vaccinations and some further support for the hardest-hit sectors and workers.
  • After adding in the indirect effects of the weak economy, that may mean the total budget deficit in 2020/21 surges to about £410bn (19.6% of GDP). That would be its highest since WWII and above the £394bn the OBR forecast in its November report.
  • To reduce the deficit back to pre-virus levels, fiscal policy needs to tighten only if the economy suffers long-term scarring effects that mean it is permanently smaller in the long run. Our view is closer to the OBR’s upside scenario that assumes 0% scarring. (See Chart 50.) As a result, we expect the budget deficit to fall back to 7% of GDP in 2021/22 and to return close to its pre-virus levels by 2024/25. (See Chart 51.)
  • The rebound in GDP and record low interest rates will keep the debt to GDP ratio between 100% and 110% over the next five years. (See Chart 52.) So taxes need only rise if the government wants spending to be higher than before the crisis and not to fill a fiscal hole. In fact, an early fiscal tightening could undermine the economic recovery, lead to a permanent loss in output and create the very fiscal hole the Chancellor is aiming to fill!
  • We don’t think that January’s COVID-19 lockdown will prompt the Bank of England to raise its QE target above £895bn. The Bank has yet to make much headway into the £150bn of QE it announced in November. (See Chart 53.) Instead, it could complete the extra £150bn of QE over six months rather than most of this year by increasing the pace of its weekly purchases from about £4.5bn to £6bn. (See Chart 54.)
  • And unlike the markets, we are not expecting Bank Rate to be reduced from +0.10% to below zero within the next year. (See Chart 55.) After all, the Bank may not be operationally ready to use negative rates until the second half of this year. And by then, we expect that the COVID-19 restrictions will have been eased and the economy will be rebounding rapidly.
  • We also disagree with the markets’ expectations that Bank Rate will rise above +0.10% in three years’ time. We think inflation will be closer to 1.5% in 2022 than 2.0%. Even if inflation did rise to 2.0%, the Bank has said it would need to be convinced it will stay above 2.0% before it tightens policy.
  • So fading expectations of negative interest rates may prompt gilt yields to rise a bit, perhaps from 0.30% now to 0.50% by the end of 2021. (See Chart 56.)

Monetary & Fiscal Policy Charts

Chart 49: Direct Policy Support in Response to the Crisis (% of GDP, including measures up to 2023)

Chart 50: Public Sector Net Borrowing (Excluding Banks, As a % of GDP)

Chart 51: Public Sector Net Borrowing (Excluding Banks, As a % of GDP)

Chart 52: Government Net Debt (As a % of GDP)

Chart 53: Bank of England Quantitative Easing (£bn)

Chart 54: BoE Asset Purchases Per Week (£bn)

Chart 55: Bank Rate Expectations (%)

Chart 56: Bank Rate & Gilt Yields (%)

Sources: Refinitiv, OBR, Bank of England, IMF, Capital Economics


Long-term Outlook

COVID-19 legacy may be higher inflation and bigger public deficits

  • The legacy of the COVID-19 crisis is unlikely to be a permanently smaller economy and is more likely to be that low inflation is sacrificed to allow bigger public deficits.
  • We don’t think the COVID-19 recession will mean that the economy is any smaller in 2050 than it would have been if COVID-19 never existed. That would be a very different outcome to after the 2008/09 GFC, when GDP shifted onto a much lower path. (See Chart 57.) This time round, the pre-crisis trend was not inflated by a housing bubble and there’s been no financial crisis to scupper the supply of credit.
  • Admittedly, by raising trade barriers and by cutting net migration from the EU, Brexit will probably chip away at future growth rates of productivity and the labour force.
  • But for some time, we have been suggesting that such effects would be offset by a rebound in productivity growth triggered by the digital revolution. If anything, by making the use of technology in the workplace more prevalent, the pandemic will probably exacerbate and bring forward that boost. And the UK’s progressive attitude to technology means it’s well placed to benefit.
  • As such, we still believe that a rebound in productivity growth in the 2020s will offset a further easing in the growth of the labour force driven by the ageing of the population to leave the economy’s potential rate of growth in the 2030s and 2040s close to 1.7%. (See Chart 58.)
  • Instead, the legacy of the COVID-19 crisis may prove to be a combination of higher inflation and bigger public deficits. Spare capacity will keep inflation below the Bank of England’s 2% target for a few years yet.
  • But if both monetary and fiscal policy are still very loose by the time GDP returns to its pre-crisis trend around the middle of the 2020s, as seems likely, then inflation will probably creep above the current 2% target.
  • If the policy regime remained the same, the Bank of England would raise interest rates to bring inflation down to 2%. But as higher rates would increase the public deficit and the public debt ratio, they would reduce the ability of the government to use fiscal policy to achieve its political aims. As such, there’s a clear incentive for the government to ensure interest rates stay low. And the UK government is probably more inclined than most to act on it. It may do that by raising the inflation target or shifting the focus to GDP growth and/or climate change.
  • Interest rates would probably still rise at some point. But they will stay low by historical standards. Indeed, by 2050 the real equilibrium interest rate (the nominal 10-year bond yield less the inflation rate) may still be just 0.75%.
  • As a result, we think the average inflation rate in the 2030s and 2040s will be 2.5%. (See Chart 59.) And the government will persistently run annual deficits worth 4-5% of GDP. Fiscal policy would still need to be tightened in the late 2020s and throughout the 2030s and 2040s to counter the declining tax-take and rising spending burden from the ageing of the population. But the government would do only what is necessary to prevent the debt ratio from rising significantly above 100%. (See Chart 60.)
  • Overall, a full recovery from the COVID-19 crisis may eventually force the government to choose between either low inflation or bigger public deficits. We think the government would choose the latter, thereby leading to permanently higher inflation.

Long-term Outlook Charts

Chart 57: Real GDP (£bn)

Chart 58: GDP, Productivity, Labour Force (%y/y)

Chart 59: CPI Inflation & Policy Rate (%)

Chart 60: Government Budget Balance & Debt

Sources: Refinitiv, Bank of England, Capital Economics

Table 2: Key Long-term Forecasts (% y/y, Averages, unless otherwise stated)

Actual

Forecasts

2006-2010

2011-2015

2016-2020

2021-2025

2026-2030

2031-2050

Real GDP

0.5

2.0

-0.8

3.7

2.2

1.7

Real consumption

0.4

2.0

-1.0

4.7

2.3

1.6

Productivity

0.3

0.6

-1.7

3.2

1.6

1.4

Employment

0.3

1.4

0.9

0.5

0.6

0.3

Unemployment rate (%, end of period)

7.9

5.4

4.5

4.3

3.5

4.0

Wages

3.0

1.6

1.4

2.9

4.0

4.2

Inflation (%)

2.7

2.3

1.7

1.8

2.4

2.6

Policy interest rate (%, end of period)

0.50

0.50

0.10

0.10

1.00

2.75

10-year government bond yield (%, end of period)

3.51

1.96

0.39

0.75

1.00

3.25

Government budget balance (% of GDP)

-7.0

-4.6

-2.7

-5.8

-4.4

-4.2

Gross government debt (% of GDP)

69.7

82.5

87.9

97.6

98.2

99.4

Current account (% of GDP)

-3.3

-4.0

-4.2

-4.4

-5.6

-5.5

Exchange Rate (US dollar per pound sterling, end of period)

1.57

1.47

1.35

1.51

1.57

1.60

Nominal GDP ($bn)

2,514

2,829

2,758

4,274

5,584

13,324

Population (millions)

63

65

67

69

71

76

Sources: UN, ONS, Refinitiv, Capital Economics


Paul Dales, Chief UK Economist, +44 (0)7939 609 818, paul.dales@capitaleconomics.com
Ruth Gregory, Senior UK Economist, +44 (0)7747 466 451, ruth.gregory@capitaleconomics.com
Thomas Pugh, UK Economist, +44 (0)7568 378 042, thomas.pugh@capitaleconomics.com
Jack France, Research Economist, jack.france@capitaleconomics.com