Economy will struggle to get back to full health - Capital Economics
UK Economics

Economy will struggle to get back to full health

UK Economic Outlook
Written by Paul Dales
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We think it will take the economy a few years to recover from an unprecedented hit to GDP of around 25% triggered by the lockdown implemented to contain the coronavirus. That’s because despite the unparalleled speed and size of the monetary and fiscal stimulus put in place to mitigate the long-term economic effects of the lockdown, the unemployment rate will probably still leap from 4% to 9% and many businesses will go bust. By the end of 2022 the economy may be 5% smaller than it would have been if the virus never existed and the cumulative loss since the end of 2019 may add up to a huge 20% of GDP.

  • Overview – We think it will take the economy a few years to recover from an unprecedented hit to GDP of around 25% triggered by the lockdown implemented to contain the coronavirus. That’s because despite the unparalleled speed and size of the monetary and fiscal stimulus put in place to mitigate the long-term economic effects of the lockdown, the unemployment rate will probably still leap from 4% to 9% and many businesses will go bust. By the end of 2022 the economy may be 5% smaller than it would have been if the virus never existed and the cumulative loss since the end of 2019 may add up to a huge 20% of GDP.
  • Forecasts – Our forecasts are based on the assumption that the measures put in place by the government to contain the spread of the coronavirus last for three months. We also assume that the Brexit transition period is extended for a year from 31st December 2020 and that some sort of trade deal is agreed thereafter.
  • Consumer Spending – One of the many ways in which this recession will be unusual is that consumer spending will be hit just as hard as business investment.
  • Investment – Just like in most recessions, business investment will fall by more than GDP. Residential investment will be just as weak, if not weaker.
  • External Demand – With other economies suffering by just as much as the UK, the recent weakening of the pound won’t provide any salvation. Both exports and imports will plunge.
  • Labour Market – Although the government’s furlough scheme will save some jobs, we still expect that 1.6 million jobs will be lost and that the unemployment rate will jump from 4% to almost 9%.
  • Inflation – There is a risk that the policy stimulus will lead to higher inflation in the medium term. But over the next few years inflation is more likely to be well below the 2% target rather than a long way above it.
  • Monetary & Fiscal Policy – The government will find it hard to reverse the surge in the debt-to-GDP ratio above 100% and the Bank of England may have to keep interest rates at 0.10% for at least three years.

Key Forecasts Table

Table 1: Key Forecasts*

2019

2020

2021

Annual (% y/y)

Q4

Q1f

Q2f

Q3f

Q4f

Q1f

Q2f

Q3f

Q4f

Average 2010-18

2019

2020f

2021f

2022f

Demand (% q/q)

GDP

0.0

-1.5

-24.0

16.0

4.8

3.2

2.4

1.4

1.0

1.9

1.4

-12.0

10.0

3.7

Consumer Spending

0.1

-5.2

-34.4

23.2

6.5

4.2

3.5

2.0

1.1

2.1

1.1

-21.0

12.0

4.6

Government Consumption

1.5

7.0

12.5

1.2

0.5

0.5

0.5

0.5

0.5

0.8

3.5

19.5

5.0

2.0

Fixed Investment

-1.2

-6.7

-37.1

26.6

7.9

5.2

3.1

2.2

2.3

2.6

0.6

-24.0

14.5

5.3

Business Investment

-1.0

-8.8

-35.0

25.0

10.0

6.0

2.6

1.5

0.7

3.6

0.3

-24.0

16.0

3.2

Stockbuilding1 (contribution, ppts)

0.3

0.4

0.2

0.0

0.0

0.0

0.0

0.0

0.0

0.1

0.2

0.0

0.1

0.0

Domestic Demand2

-1.4

-1.0

-24.8

16.7

5.1

3.4

2.7

1.7

1.1

2.1

1.6

-14.0

10.7

4.0

Exports

5.0

-4.5

-19.5

15.0

4.2

2.8

1.4

0.5

0.6

3.3

4.8

-6.0

9.0

2.3

Imports

0.4

-3.3

-21.9

17.1

5.0

3.3

2.1

1.3

1.1

3.8

4.6

-13.0

11.5

3.7

Net Trade2 (contribution, ppts)

1.4

-0.4

0.6

-0.4

-0.2

-0.1

-0.2

-0.2

-0.2

-0.1

0.0

2.2

-0.6

-0.4

Labour Market (% q/q)

 

 

 

Unemployment (ILO measure, %)

3.8

4.6

8.5

8.0

6.5

5.9

5.8

5.7

5.6

6.3

3.8

7.0

5.7

5.3

Employment

0.6

-0.8

-4.3

0.6

1.8

0.7

0.2

0.2

0.2

1.2

1.1

-3.0

1.5

1.0

Total Hours Worked

-0.1

-0.6

-20.4

15.4

3.4

4.0

0.2

0.2

0.2

0.4

1.4

-9.0

8.0

1.0

Productivity (output per hour)

0.1

-0.8

-4.5

0.5

1.4

-0.8

2.2

1.2

0.7

0.5

0.0

-3.3

1.8

2.8

Income & Saving (%q/q)

 

 

 

Nominal Average Weekly Earnings3

0.6

0.5

-6.4

5.7

-0.1

-0.2

1.5

0.4

0.8

2.0

3.5

-0.2

2.0

3.0

Real Average Weekly Earnings4

0.4

0.4

-6.5

5.6

-0.4

-0.2

1.0

0.0

0.2

-0.2

1.6

-1.4

1.5

1.3

Real Household Disposable Income

1.7

-3.3

-8.6

7.5

1.5

-3.7

1.1

3.5

0.9

1.8

1.3

-5.0

1.4

1.6

Saving Ratio (%)

6.2

7.7

33.6

24.1

20.3

13.9

11.7

13.2

13.0

8.5

5.7

21.5

13.0

10.5

Prices (% y/y)

 

 

 

CPI

1.4

1.7

0.8

0.6

0.7

0.5

0.9

1.1

1.4

2.3

1.8

1.0

1.0

1.6

Core CPI5

1.6

1.7

1.6

1.3

1.2

1.1

1.0

1.3

1.4

2.1

1.7

1.5

1.2

1.7

CPIH

1.4

1.7

0.8

0.5

0.5

0.5

0.9

1.2

1.5

2.1

1.7

0.9

1.0

1.7

RPI

2.2

2.4

1.0

0.6

0.6

0.4

1.4

1.8

2.2

3.1

2.6

1.0

1.4

2.7

RPIX

2.2

2.6

1.6

1.2

1.2

0.9

1.3

1.7

2.1

3.2

2.6

1.6

1.5

2.5

Nationwide House Prices (end period)

1.5

3.0

0.7

-2.4

-3.0

-3.7

-0.7

2.8

3.0

3.6

1.5

-3.0

3.0

2.0

Monetary Indicators (end period)

 

 

 

Bank Rate (%)

0.75

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.48

0.75

0.10

0.10

0.10

10-Year Gilt Yield (%)

0.83

0.27

0.26

0.26

0.25

0.25

0.25

0.25

0.25

2.06

0.83

0.25

0.25

0.50

Sterling Trade-weighted Index

80.8

78.1

78.1

78.3

78.9

80.6

81.7

82.5

84.1

82.3

80.8

78.9

84.1

84.1

$/£

1.33

1.24

1.24

1.24

1.25

1.27

1.28

1.29

1.30

1.49

1.33

1.25

1.30

1.30

Euro/£

1.18

1.14

1.14

1.14

1.14

1.17

1.19

1.21

1.24

1.21

1.18

1.14

1.24

1.24

Current Account & Public Finances

 

 

 

Current Account (£bn)

-6

-6

-2

-10

-14

-13

-13

-14

-15

-74

-84

-35

-55

-70

% of GDP

-1.0

-1.2

-0.4

-2.2

-2.8

-2.6

-2.5

-2.6

-2.6

-3.9

-3.8

-1.7

-2.6

-3.0

PSNB6 (£bn, financial year)

91

47

300

200

135

% of GDP (financial year)

5.1

2.1

15.5

9.0

6.0

Global (% y/y)

 

 

 

World GDP7(CE estimate for China)

3.0

-3.0

-9.5

-4.4

-1.5

6.6

14.5

8.9

5.9

3.6

2.9

-4.5

8.5

3.3

Oil Price (Brent, $pb, end period)

66

23

33

35

45

48

50

53

55

80

66

45

55

60

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 restrictions on activity created by the coronavirus lockdown last for three months from late March to late June. Assumes the UK and the EU agree to extend the Brexit transition period for a year from 31st December 2020 and strike some sort of trade deal thereafter perhaps in a step-by-step approach.


Overview

Effects of the huge hit to the economy will linger

  • Our view that the coronavirus crisis is delivering an unprecedented hit to GDP that the economy will take many years to recover from is more downbeat than the consensus.
  • Economic activity started falling off a cliff even before the full lockdown to contain the spread of the virus was announced on 23rd March. We’re assuming that the lockdown will last until at least May and that the restrictions will then be eased only gradually.
  • We estimate the restrictions will trigger a peak-to-trough fall in GDP of 25% in the first half of this year, which would dwarf the 6% drop during the Global Financial Crisis (GFC). (See Chart 1.) Sectors like arts & entertainment and accommodation & food are likely to be hit hardest, while agriculture, public admin and health may benefit. (See Chart 2.) Household spending will probably be hit just as hard as business investment, which is unusual as recessions tend to hurt investment more.
  • After the lockdown ends, GDP will rise rapidly and probably more quickly than after previous recessions. (See Charts 3 & 4.) But despite the huge support put in place by policymakers to limit the lasting damage of the crisis, we doubt that GDP will get back to its previous level for a few years.
  • The government’s spending pledges and tax deferrals may cost £100bn (4.5% of GDP). With the weak economy set to push spending even higher and tax revenues even lower, the budget deficit may leap from 2% of GDP to 15% in 2020/21 and debt may climb from 80% of GDP to over 105%. (See Chart 5.)
  • It appears as though the Bank of England’s decisions to cut interest rates from 0.75% to a record low of 0.10%, raise quantitative easing by £200bn (9% of GDP) and provide more liquidity and loans to banks and businesses have staved off the risk of a financial crisis.
  • But we still expect that the weak economy will lead to unemployment rising by 1.6 million to 3.0 million. That would raise the rate from 4% to almost 9%, thereby surpassing the peak during the GFC. (See Chart 6.) And around 110,000 businesses may go bankrupt, which would be similar to during the GFC. Both households and businesses may also decide to maintain higher savings in the future.
  • Such a lingering fall in the ability and desire to spend explains why by the end of 2022 GDP may still be about 5% (£100bn) lower than if the virus never existed. The cumulative loss of output in 2020, 2021 and 2022 may be about 23% of GDP (£500bn). (See Chart 7.) The recovery would be even softer if a second wave of the virus led to renewed restrictions.
  • There’s a risk that the policy stimulus will boost inflation once the economy eventually returns to full health. But the recent plunges in energy prices and demand will drag down inflation in the near term. We think it will fall to 0.5% in the middle of this year and stay below 2% for the next few years. (See Chart 8.) That explains why we expect the Bank of England to keep interest rates at 0.10% for the next three years.
  • Brexit may come back onto the agenda later this year. Our forecasts are based on an assumption that the transition period will be extended by a year from 31st December 2020 and that there is a deal of some sort thereafter.
  • Overall, we expect that a 12% fall in GDP in 2020 as a whole will only be partially offset by a 10% rise in 2021 to leave GDP struggling to get back to its pre-crisis level.

Overview Charts

Chart 1: GDP (% y/y)

Chart 2: Peak-to-Trough Change in GDP, H1 2020 (%)

Chart 3: GDP (% q/q)

Chart 4: Level of GDP (Pre-Recession Peak = 100)

Chart 5: Public Net Borrowing Requirement (% of GDP)

Chart 6: ILO Unemployment Rate (%)

Chart 7: Level of GDP (Q4 2019 = 100)

Chart 8: CPI Inflation (%)

Sources: Refinitiv, Capital Economics


Consumer Spending

Consumption to bear the brunt of the recession

  • The lockdown of the economy will result in a sharp drop in consumption in the next few months. Of course, no one knows how big the fall will be, but our 35% q/q decline in Q2 would dwarf the falls in the GFC. (See Chart 9.) As a result, we expect consumption to contract by around 20% this year as a whole. Admittedly, spending should rebound fairly quickly once the lockdown ends, leading to growth of about 12% in 2021. But it will still take years for it to recover completely.
  • Measures to control the spread of the coronavirus, including the nationwide closure of all non-essential businesses and restrictions on movements, have already triggered a significant decline in spending. In-person restaurant dining and cinema ticket sales had all-but stopped completely by mid-March. (See Chart 10.)
  • Moreover, consumer confidence has been falling for a while now, with virus fears compounded by the recent plunge in the stock market. (See Chart 11.) This suggests that even in areas subject to less severe restrictions, spending is still likely to take a big hit.
  • Admittedly, consumption isn’t going to collapse entirely. Several major components of spending – including housing, food & drink and financial services, which account for 50% of the total – will be little affected by the pandemic and may even receive a boost. (See Chart 12.) Nevertheless, with other categories of spending likely to plunge – particularly transport, recreation, restaurants and hotels – overall consumption will still decline significantly.
  • This means the coronavirus downturn is likely to look very different to past recessions – not only because of the speed and scale of the slump, but also its composition. Whereas consumption usually falls by less than GDP during a recession, this time it may fall by more. (See Chart 13.)
  • When the spread of the virus slows and restrictions on activity are eventually lifted, spending should start to rebound quickly. The government has put in place unprecedented levels of support for workers, which means that incomes will not be hit as hard as the fall in GDP and the increase in unemployment would suggest. Indeed, we think that household savings will soar over the next few months as consumption falls by more than incomes. (See Chart 14.) This will give shoppers a solid base to ramp up spending once the crisis is over.
  • That said, a complete recovery will still take years. Thousands of workers have already been laid off as a result of the lockdown and some of those jobs will be lost permanently. That will lead to a 9% q/q decline in real disposable incomes in Q2, which will only be gradually reversed over the next couple of years. (See Chart 15.)
  • The good news is that household balance sheets were in decent shape before the virus struck. Indeed, debt servicing costs were at a record low even before the further cut in interest rates. So even if the level of debt rises, the cost of serving it should remain low. (See Chart 16.)
  • This is one reason to believe that, while the initial hit to consumption will be far larger than during the GFC, the worst part of the coronavirus downturn might not last as long.

Consumer Spending Charts

Chart 9: Consumer Spending

Chart 10: High Street Footfall & Cinema Tickets (% y/y)

Chart 11: Consumer Confidence & Household Spending

Chart 12: Breakdown of Consumption (% of Total)

Chart 13: Peak-to-Trough Change in Past Recessions (%)

Chart 14: Household Saving Ratio (% of Disp. Income)

Chart 15: Real Household Disposable Income

Chart 16: Household Interest & Capital Repayments as % of Disposable Income

Sources: Refinitiv, Springboard, IMDB, Capital Economics


Investment

Crisis to deliver lasting hit to investment

  • We expect business investment to contract by 25% in 2020 as a whole, larger than the 15.6% hit seen in 2009. And with the economic legacy of the coronavirus crisis and Brexit uncertainty likely to hold back investment for some years to come, we forecast only a partial recovery of 16% in 2021 and 3% in 2022.
  • In the past three recessions, business investment has fallen further than GDP. This time is unlikely to be different as the coronavirus lockdown affects the installation of equipment and the plunge in demand causes firms to put plans on ice. We expect a peak-to-trough fall of 40%, larger than the 25% decline in GDP. (See Chart 17.)
  • One key difference in this downturn is our expectation that the slump in business investment will be roughly in line with the decline in household consumption as both are hit hard by the lockdown. This is in stark contrast to the experience of past recessions, such as in 2009 when business investment dropped by five times as much as consumer spending. (See Chart 18.)
  • Not all parts of business investment will be hit equally. Intellectual property investment – which accounts for 39% of business investment and includes R&D and software – is likely to hold up relatively well as activity in a number of service sectors has continued via remote working. But the widespread factory closures and the reduction in construction activity mean that investment in transport equipment (8% of business investment), building and structures (33%) and machinery (21%) will fall sharply. (See Chart 19.)
  • There is also a risk that tightening credit standards force firms to scale back future investment plans. Indeed, the rise in corporate bond yields has increased the cost of borrowing for those firms looking to fund investment projects using external funds. (See Chart 20.)
  • And the legacy of the crisis may affect business investment for years. The deterioration in corporate balance sheets as firms take on more debt to get through the crisis may prompt firms to prioritise paying off debt over investment. Some firms may also decide it makes sense to maintain a higher level of savings, just as they did after the GFC. (See Chart 21.)
  • Lingering Brexit uncertainty may also prevent business investment from eventually settling at the pre-EU referendum rates of 5% or so once the virus is contained. Firms may begin to worry again about what sort of trade deal will be agreed with the EU (if any) by the end of the transition period, which we expect will be extended by a year from 31st December 2020.
  • Our forecasts of a protracted recovery in business investment, after an initial rebound following the end of the lockdown, is similar to the recoveries seen after previous recessions. (See Chart 22.)
  • We expect residential investment to be hit just as hard as business investment, dropping by 30% in 2020 as construction activity is put on ice. (See Chart 23.) Government investment will probably hold up better. But it is now doubtful that the government will pursue the new investment spending it planned in the March Budget.
  • Overall, we think that total investment will fall by about 24% in 2020, knocking 4ppts off annual GDP growth, before rising by 15% in 2021 and by 5% in 2022. (See Chart 24.)

Investment Charts

Chart 17: Investment & GDP (Peak-to-Trough, %)

Chart 18: Business Investment & Consumption (% y/y)

Chart 19: Breakdown of Business Investment (% y/y)

Chart 20: 10-Year Corporate Bond Yield (%)

Chart 21: PNFC’s Financial Balance (% of GDP)

Chart 22: Business Investment (100 = Pre-Crisis Peak)

Chart 23: Construction & Residential Investment (% y/y)

Chart 24: Investment Contribution to GDP (y/y, ppts)

Sources: Refinitiv, Bloomberg, Capital Economics


External Demand

A big collapse in trade

  • Alongside the plunge in domestic demand this year, the external sector will also be hit hard as other countries have closed parts of their economies to slow the spread of the virus. Imports may fall further than exports, so net trade may boost GDP growth in 2020. But this won’t offset much of the huge drop in domestic demand.
  • Due to the low level of imports in late 2019, the UK recorded a rare trade surplus around the turn of the year. Admittedly, the surplus was flattered by large net exports of gold bullion and sharp falls in imports following stockbuilding ahead of the Brexit deadlines. But the underlying trade balance still improved. (See Chart 25.)
  • This may continue as we suspect that the hit to the UK economy from the coronavirus lockdown will be a bit worse than in some other economies, resulting in imports falling further than exports.
  • The record low in the suppliers’ delivery times balance of the manufacturing PMI in March was the first sign that trade was being disrupted by the virus. (See Chart 26.) But widespread lockdowns mean plunging demand, rather than supply disruption, is the main drag on trade.
  • Indeed, our forecast that the global economy will contract by 4.5% this year suggests that 2020 will be the worst year for the world economy since the end of the Second World War. That may cause a sharp reduction in exports of about 6% in 2020 as a whole. (See Chart 27.)
  • But imports will probably fall by more. Admittedly, as the shutdown affects the services sector most severely, where most inputs aren’t imported, arguably the effect on imports will be smaller. But note that the UK does import a large amount of travel services that will fall close to zero. (See Chart 28.)
  • More generally, the fall in demand from the UK’s large consumer sector and the sharp fall in business investment, which are both import intensive, suggests that the collapse in domestic demand will be a big drag on imports. We are forecasting a 14% fall in domestic demand in 2020 as a whole, which points to a collapse in imports of at least 13%. (See Chart 29.) That would be about twice the size of the fall in exports. (See Chart 30.)
  • As the sharp fall in the pound at the start of March has already been unwound, and we expect it to be broadly stable for the remainder of the year, we doubt the currency will have much bearing on trade.
  • The result is that, following a deficit of 1.3% of GDP in 2019, the trade balance may record a surplus in 2020 of about 1.2% of GDP. As domestic demand recovers, the trade surplus will shrink in 2021 and a deficit will emerge in 2022. That will cause net trade to be a small drag on GDP growth after 2020. (See Chart 31.)
  • The trade surplus will cause the current account deficit to narrow from 4% of GDP in 2019 to 2-3% of GDP in 2020, 2021 and 2022. (See Chart 32.) That’s one reason why we think a sustained lurch down in sterling is unlikely.

External Demand Charts

Chart 25: Trade in Goods & Services (Ex. valuables & oil unless otherwise stated, £bn)

Chart 26: PMI Suppliers’ Delivery Times

Chart 27: Trade Partner GDP & UK Exports (% y/y)

Chart 28: Trade in Services, 2019 (£bn)

Chart 29: UK Domestic Demand & Imports

Chart 30: Export & Import Volumes (% y/y)

Chart 31: Net Trade Contribution to y/y GDP (ppts)

Chart 32: Breakdown of the Current Account Balance (% GDP)

Sources: Refinitiv, IHS Markit, ONS, Capital Economics


Labour Market

Unemployment rate to top GFC high

  • With thousands of people already laid off as a result of the coronavirus lockdown, we forecast that the unemployment rate will jump from 4% to almost 9% in the coming months. Most of that jump should quickly be reversed once the lockdown ends, but we still expect the unemployment rate to remain elevated over the next few years. (See Chart 33.)
  • The early indicators suggest that the labour market has already shed a large number of jobs. Surveys such as the REC Report on Jobs and the All-Sector PMI suggest that firms were laying people off in March. (See Chart 34.) And the surge in the number of people applying for Universal Credit suggests that the number of people laid off could be in the millions, although not all of those applying for Universal Credit will have been made unemployed. (See Chart 35.)
  • Most of the layoffs will be in the retail, restaurants & hotels, recreation and transport sectors, which together account for about 10 million jobs. (See Chart 36.) Other sectors that involve less face-to-face contact, such as construction and manufacturing, will face smaller falls. These losses may be partially offset by higher demand for labour in some sectors, such as food shops and healthcare. But these sectors will only be able to absorb a small fraction of those made unemployed.
  • Typically, the unemployment rate rises by about 0.3% for every 1% fall in GDP. (See Chart 37.) In theory, this should mean that our forecast of a 25% drop in GDP would send the unemployment rate soaring from 3.9% in January to above 12%. However, the unprecedented level of government support, such as paying 80% of furloughed workers’ wages, and the relatively short duration of the recession will blunt the impact. This is why we think that the unemployment rate will probably peak at 9% instead. But even that would top the high of 8.4% in the GFC and would be consistent with the number of unemployed people rising by 1.6 million to 3.0 million.
  • As furloughed employees won’t be working, the number of hours worked in the economy is likely to slump by 20% over the next few months. That would be far more than the 5% drop we have pencilled in for employment. (See Chart 38.)
  • Usually such a fall in hours worked would result in a similar drop in earnings. However, the government will pay furloughed workers 80% of their salary up to £2,500 per month. As such, the hit to incomes will be significantly smaller than implied by the drop in hours worked. (See Chart 39.) What’s more, the government has beefed up unemployment benefits, which will further reduce the hit to incomes.
  • That said, millions of workers will still have to take at least a 20% pay cut and over a million more will become unemployed. So despite policymakers’ best efforts, real household disposable income will still fall by about 9% q/q in Q2 and by 5% in 2020 as a whole. (See Chart 40.) That would be a significantly larger hit than the 2% fall in the GFC.
  • The key message is that the impact on the labour market is likely to be more severe than in the GFC. And the big risk is that some of the rise in the unemployment rate could become permanent if sectors like travel and entertainment do not fully recover.

Labour Market Charts

Chart 33: ILO Unemployment Rate (%)

Chart 34: Employment Surveys (Standardised)

Chart 35: New Applications for Universal Credit (000s)

Chart 36: Employment by Sector (000s)

Chart 37: GDP Growth & Change in Unemployment

Chart 38: Total Hours Worked & Employment (% q/q)

Chart 39: Hours Worked & Average Earnings (% q/q)

Chart 40: Breakdown of RHDI (Ppts)

Sources: Refinitiv, REC, IHS Markit, Capital Economics


Inflation

Energy prices and recession push inflation close to zero

  • The coronavirus-related collapse in energy prices means that CPI inflation will fall close to zero in the second half of this year. (See Chart 41.) And inflation is likely to remain muted for the next couple of years as the hit to demand lingers after the lockdown ends. Worries of high inflation due to the Bank of England’s actions are for the longer term, and even then may prove unjustified.
  • The slump in oil prices from $60 per barrel to $30 per barrel will reduce the price of petrol from £1.25 to about £1.00 and knock about 0.3 percentage points (ppts) off inflation in 2020. (See Chart 42.) Household energy bills should also fall, taking a further 0.1ppts off inflation.
  • The near-term impact of the pandemic on prices is not all in one direction, though, because it is a shock to both supply and demand. The supply shock is inflationary, given that there are fewer goods and services to meet a given amount of demand. There is anecdotal evidence of supermarket prices rising. But demand is also lower as households and businesses spend less, which is disinflationary. Airfares and clothes prices have most definitely fallen. And for many items, like restaurant meals, the ONS will struggle to collect prices.
  • Our view is that while a lot of the supply shock should be reversed when the lockdown ends, demand will be weaker for longer due to the fall in employment and consumers remaining cautious. The Phillips curve relationship between inflation and unemployment is weak, but our forecast that pay will fall this year suggests that core services inflation will ease. (See Chart 43.)
  • What’s more, we doubt the sharp fall in sterling in March will push up inflation much. Normally this might boost inflation by a full percentage point. (See Chart 44.) But most of the fall has already been unwound. And against the background of an unprecedented slump in demand, producers and retailers will surely absorb most of the increase in import prices in their margins. As such, we have assumed that only some of sterling’s fall feeds through to inflation, providing only a partial offset to the disinflationary influences of energy prices and the slump in demand.
  • As a result, we think that core inflation will decline from 1.7% in February to 1.0% early next year and overall CPI inflation will drop from 1.7% in February to 0.5% in August. (See Charts 45 & 46.) Even when this drag fades and core inflation starts to rise, we doubt inflation will reach the 2% target before 2023.
  • Meanwhile, RPI inflation will fall even more sharply, from 2.5% to a trough of 0.4%, due to the drag from lower mortgage repayments triggered by lower interest rates and lower house prices. (See Chart 47.)
  • There are fears that the increase in the monetary base due to the Bank of England’s actions will lead to runaway inflation. And high inflation would erode the debt the government has taken on to deal with the crisis.
  • But the Bank’s actions are more of an anti-depressant than a stimulus. And as the Bank remains independent of the government, should inflation start to rise after the crisis it can reverse the extra central bank money by selling gilts to bring inflation down. That’s why, as has been the case during previous bouts of QE, investors haven’t priced in higher inflation over the next decade. (See Chart 48.)

Inflation Charts

Chart 41: CPI Inflation (%)

Chart 42: Sterling Oil & Fuel Prices

Chart 43: Average Earnings & Core Services CPI

Chart 44: Sterling TWI & Core Goods CPI

Chart 45: Core Inflation (%)

Chart 46: Contributions to CPI Inflation (ppts)

Chart 47: RPI & CPI Inflation (%)

Chart 48: QE & 10-Year Breakeven Inflation (%)

Sources: Refinitiv, Capital Economics, BEIS


Monetary & Fiscal Policy

Huge stimulus mitigates longer-term damage

  • The unprecedented monetary and fiscal support will do little to alleviate the near-term fall in GDP. But it will help to mitigate some of the long-term damage caused by the crisis.
  • There can be no quibbling about the size and the speed of policymakers’ response to the coronavirus crisis. The government has been quick to introduce measures worth an estimated £100bn (4.5% of GDP) that includes higher expenditure, tax relief, grants and loans. That’s more than double the package seen after the financial crisis in 2008. (See Chart 49.)
  • These measures taken together with the hit to the economy, which further lowers tax receipts and increases welfare spending, are likely to raise the budget deficit in 2020/21 from 2% of GDP to about 15%. This is far above the peak of 10.2% in 2009/10 after the GFC and would mean that the deficit reaches a level not seen since the Second World War. (See Chart 50.) It is also likely to cause the debt to GDP ratio to climb from 80% to 105%, its highest since the 1960s. (See Chart 51.)
  • The Bank of England has also pulled out just about every stop, slashing interest rates from 0.75% to a record low of 0.10% and announcing an increase in its quantitative easing (QE) programme of £200bn as soon as is “operationally possible”. The latter is at least as large as the QE packages announced in 2009 (£200bn), 2011-12 (£175bn) and 2006 (£70bn). (See Chart 52.) This will increase the Bank’s balance sheet from 20% of GDP to 29%, a rise that took more than six months after the GFC.
  • The Bank’s bond purchases and liquidity provisions have helped to ease the strains in the financial markets. (See Chart 53.) And they will support the recovery once the coronavirus lockdown ends.
  • Even so, policymakers cannot prevent a big fall in GDP in Q2 as many parts of the economy have been shut down. And given our forecast that the economy will be about 5% smaller at the end of 2022 than would have been the case if the coronavirus did not exist, there will be long-lasting effects on the public finances.
  • That is why we expect the budget deficit to stay high over the next few years and why we and the markets see little prospect of the Bank raising interest rates from 0.10% within the next few years. (See Charts 54 & 55.)
  • At least the financial markets’ ability to absorb the increase in government debt will not need to be tested as the Bank’s huge QE programme will hoover up government bonds.
  • Admittedly, it is only a small step from here to full-blown helicopter money. After all, the government is spending more and the Bank is financing it by creating money. But it is not clear yet if the key ingredient of so-called helicopter money – that the increase in central bank money is permanent – is present. Indeed, the Bank expects QE to be temporary.
  • That is why neither we nor the markets expect the policy support to lead to much higher inflation. (See Chart 56.) Nor are the markets worried about a sovereign rating downgrade.
  • But at some point, the government will probably need to reduce its debt burden. That leaves it with an unenviable choice of whether to let debt be eroded gradually via economic growth, to try to inflate it away, or to resort to more austerity.

Monetary & Fiscal Policy Charts

Chart 49: Gov’t Fiscal Stimulus & BoE QE (% of GDP)

Chart 50: Public Sector Net Borrowing (% of GDP)

Chart 51: Public Sector Net Debt (% of GDP)

Chart 52: BoE Asset Purchase Facility

Chart 53: Gilt Yields (%)

Chart 54: Bank Rate & 10-Year Gilt Yield (%)

Chart 55: Market Expectations for Bank Rate Implied by OIS Rates (%)

Chart 56: 10-Year Break-Even Inflation Rate (%)

Sources: Refinitiv, OBR, Bloomberg, BoE, Capital Economics


Paul Dales, Chief UK Economist, +44 7939 609 818, paul.dales@capitaleconomics.com
Ruth Gregory, Senior UK Economist, +44 7747 466 451, ruth.gregory@capitaleconomics.com
Thomas Pugh, UK Economist, +44 7568 378 042, thomas.pugh@capitaleconomics.com
Andrew Wishart, UK Economist, +44 7427 682 411, andrew.wishart@capitaleconomics.com
James Yeatman, Research Economist, +44 20 7808 4694, james.yeatman@capitaleconomics.com