Rapid recovery to limit scarring - Capital Economics
UK Economics

Rapid recovery to limit scarring

UK Economic Outlook
Written by Paul Dales
Cancel X

While we think the reopening of the economy and the vaccine rollout will allow GDP to return to its pre-pandemic level a bit earlier than most forecasters, the big difference between us and the consensus is that we don’t think the pandemic will significantly scar the future level or growth rate of GDP. Such a fast and full economic recovery will prompt inflation to rise above the 2% target and stay there. But as we don’t envisage that happening until 2023 or 2024, we think the markets have gone too far in pricing in interest rate hikes before the end of 2022. We think Bank Rate will stay at 0.10% until 2025.

  • Overview – While we think the reopening of the economy and the vaccine rollout will allow GDP to return to its pre-pandemic level a bit earlier than most forecasters, the big difference between us and the consensus is that we don’t think the pandemic will significantly scar the future level or growth rate of GDP. Such a fast and full economic recovery will prompt inflation to rise above the 2% target and stay there. But as we don’t envisage that happening until 2023 or 2024, we think the markets have gone too far in pricing in interest rate hikes before the end of 2022. We think Bank Rate will stay at 0.10% until 2025.
  • Forecasts – Our forecasts are based on the assumptions that the domestic economy will be reopened in line with the government’s roadmap, that few domestic restrictions are required after June and that the government achieves its target to give all adults their first dose of the COVID-19 vaccine by the end of July.
  • Consumer Spending – Even if households just return to spending a more normal share of their incomes, consumer spending will be able to drive the recovery. And if households go further and dip into their stocks of savings too, then the recovery in GDP will be even stronger than we expect.
  • Investment – Our forecast that it will take just two-and-a-half years for business investment to regain its pre-crisis peak, which would be half as long as after the Global Financial Crisis (GFC), is consistent with the pandemic not dealing a lasting big blow to the economy’s capital stock and future GDP growth rates.
  • External Demand – We think that a strong recovery in the domestic economy will boost imports, but that the weaker performance of the euro-zone and some lingering Brexit effects will mean UK exports lag behind. As such, net trade will probably be a drag on GDP growth this year.
  • Labour Market – Employment may be closer to a trough than most realise. And although the unemployment rate may yet rise from 5.0% in January to a peak of around 6.0% early in 2022, the rapid economic recovery will probably drive it back down to just over 4.0% by the end of 2023.
  • Inflation – Energy effects will probably temporarily push CPI inflation above the 2% target later this year. But we doubt that the strong recovery and all the policy stimulus will boost underlying price pressures by enough to keep inflation above 2% until late in 2023.
  • Monetary & Fiscal Policy – Our forecast that the economic recovery will be more complete than the Office for Budget Responsibility (OBR) expects suggests that the budget deficit will decline quicker. The tax hikes and spending cuts that most fear may therefore be avoided.
  • Long-term Outlook – Beyond the next few years, we doubt that the legacy of the COVID-19 crisis will be a permanently smaller economy and instead may be higher inflation and bigger public deficits.

Key Forecasts Table

Table 1: Key Forecasts*

2020

2021

2022

Annual (% y/y)

Q4

Q1f

Q2f

Q3f

Q4f

Q1f

Q2f

Q3f

Q4f

Average 2010-19

2020

2021f

2022f

2023f

Demand (% q/q)

GDP

1.3

-1.8

3.0

3.5

2.3

1.5

1.2

0.8

0.8

1.8

-9.8

6.0

7.5

2.8

Consumer Spending

-1.7

-1.5

2.0

4.4

3.5

1.5

1.2

1.0

1.0

1.8

-10.6

4.7

8.6

3.7

Government Consumption

6.7

-3.3

8.0

4.4

1.5

-1.6

-2.1

-1.0

0.0

1.2

-6.5

12.9

1.4

0.7

Fixed Investment

4.4

0.8

1.0

2.3

1.9

0.8

1.1

1.2

1.2

3.0

-8.8

9.3

5.4

1.4

Business Investment

5.9

-2.0

1.5

3.0

2.5

1.0

2.0

2.0

2.0

3.7

-10.2

5.1

8.0

0.9

Stockbuilding1 (contribution, ppts)

1.4

-1.2

0.2

0.2

0.2

0.0

0.0

0.0

0.0

0.2

-0.5

0.2

0.3

0.0

Domestic Demand2

2.7

-2.6

3.2

4.2

3.0

0.7

0.5

0.6

0.8

2.0

-10.5

8.0

6.8

2.7

Exports2

6.1

-7.0

5.0

3.5

4.0

5.0

4.0

2.0

1.5

3.1

-15.8

0.7

16.2

6.6

Imports2

11.0

-9.0

5.5

6.0

6.0

2.0

1.5

1.5

1.5

3.5

-17.8

7.7

13.5

6.1

Net Trade2 (contribution, ppts)

-1.5

0.8

-0.2

-0.8

-0.7

0.8

0.7

0.1

0.0

-0.1

0.8

-2.1

0.4

0.0

Labour Market (% q/q)

Unemployment (ILO measure, %)

5.1

4.9

5.1

5.3

5.8

6.1

5.8

5.3

4.8

6.0

4.5

5.3

5.5

4.3

Employment

-0.4

0.1

-0.2

-0.2

0.2

0.7

0.7

0.6

0.6

1.2

-0.5

-0.9

1.7

1.8

Total Hours Worked

5.8

-1.7

2.4

2.9

1.8

0.9

0.7

0.3

0.4

1.4

-10.3

5.7

5.1

1.1

Productivity (output per hour)

-4.3

-0.1

0.6

0.6

0.6

0.6

0.5

0.5

0.4

0.5

0.5

0.3

2.2

1.7

Income & Saving (%q/q)

Nominal Average Weekly Earnings3

2.0

0.3

0.8

0.7

0.3

0.3

0.3

0.3

0.4

2.1

1.8

5.0

1.6

2.5

Real Average Weekly Earnings4

5.3

0.2

-0.3

0.4

-0.4

0.4

-0.3

0.2

-0.3

-0.1

1.0

3.4

1.5

0.9

Real Household Disposable Income

0.9

-0.5

1.2

0.5

0.9

0.6

0.9

0.7

0.5

1.7

0.1

2.7

3.0

2.7

Household Saving Rate (%)

16.1

17.0

16.3

13.0

10.7

9.9

9.7

9.4

9.0

8.2

16.3

14.2

9.5

8.6

Prices (% y/y)

CPI

0.5

0.6

1.5

1.4

2.1

1.9

1.5

1.2

1.0

2.2

0.9

1.4

1.4

1.6

Core CPI5

1.3

1.1

1.1

0.9

1.3

1.4

1.5

1.5

1.3

2.1

1.4

1.1

1.4

1.9

CPIH

0.8

0.8

1.5

1.3

1.7

1.6

1.3

1.2

1.1

2.1

1.0

1.3

1.3

1.6

RPI

1.1

1.4

2.6

2.6

3.2

2.9

2.5

2.2

2.0

3.1

1.5

2.5

2.4

2.5

RPIX

1.4

1.6

2.6

2.5

3.1

2.8

2.4

2.1

1.9

3.1

1.7

2.5

2.3

2.4

Nationwide House Prices (end period)

6.5

6.3

6.9

5.8

3.0

2.2

1.8

1.8

2.5

2.9

6.5

3.0

2.5

3.0

Monetary Indicators (end period)

Bank Rate (%)

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.53

0.10

0.10

0.10

0.10

Announced BoE QE (£bn)

895

895

895

895

895

895

895

895

895

372

895

895

895

895

10-Year Gilt Yield (%)

0.24

0.83

0.97

1.11

1.25

1.31

1.38

1.44

1.50

1.86

0.24

1.25

1.50

1.50

Sterling Trade-weighted Index

78.9

82.2

82.5

83.5

84.5

84.5

84.6

84.7

84.7

82.1

78.9

84.5

84.7

82.3

Sterling Trade-weighted Index (%y/y)

-2.3

5.4

7.9

8.5

7.1

2.8

2.5

1.4

0.3

0.1

-2.3

7.1

0.3

-2.8

$/£

1.37

1.38

1.40

1.40

1.40

1.40

1.40

1.40

1.40

1.46

1.37

1.40

1.40

1.40

Euro/£

1.12

1.18

1.18

1.20

1.22

1.22

1.22

1.22

1.22

1.20

1.12

1.22

1.22

1.17

Current Account & Public Finances

Current Account (£bn)

-26

-22

-22

-26

-30

-26

-22

-21

-21

-75

-74

-100

-90

-75

% of GDP

-4.8

-4.0

-4.0

-4.6

-5.2

-4.4

-3.7

-3.6

-3.4

-3.9

-3.5

-4.5

-3.8

-3.0

Public Borrowing6 (£bn, financial year)

87

325

230

85

35

% of GDP (financial year)

4.8

15.5

10.1

3.5

1.4

Public Net Debt6 (% GDP, Q4-Q3 year)

79

98

105

104

101

Global

Oil Price (Brent, $pb, end period)

52

65

70

75

70

68

65

63

60

76

52

70

60

55

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

* Assumes that COVID-19 restrictions are eased in line with the government’s roadmap and that few restrictions are required beyond June.


Overview

Strong recovery, but loose policy

  • We continue to believe that the recovery will be fast enough and broad enough to prevent COVID-19 from leaving major lasting scars on the economy. But as CPI inflation may not stick above the 2% target until 2023 or 2024, we doubt the Bank of England will raise interest rates until 2025.
  • Our assumptions that the government will continue to reopen the domestic economy over the coming months and that all adults will be vaccinated by the end of July underpin our forecast that GDP will return to its pre-pandemic peak by around the turn of next year after being 7.8% below in February. (See Charts 1 & 2.)
  • That’s an earlier return than most forecasters are expecting as we think households will embark on a spending spree in pubs, restaurants and theatres. Some of this will be financed by the furlough scheme supporting incomes until it ends in September. But most of it will be funded by households going back to spending a greater share of their income. If they spent some of their stocks of savings too, the recovery in GDP would be faster and stronger.
  • Businesses will probably also add to the recovery. Unlike after the GFC when it took business investment five years to recoup its previous peak, this time we think it will take only two-and-a-half years. That said, the weaker outlook for the euro-zone and some Brexit issues will probably mean that UK exports lag behind the recovery. (See Chart 3.)
  • Our GDP forecasts suggest that after falling by 2.1% since the start of the crisis, employment is now close to a trough. So although the unemployment rate may yet rise from 5.0% in January to around 6.0% early next year as the recovery entices more people to look for work, we think it will fall close to 4.0% by late 2023.
  • Our view that the household saving rate, the unemployment rate and business investment will all get back to or close to their pre-crisis levels in 2023 suggests the pandemic won’t permanently scar the level or rate of GDP growth. (See Chart 4.) Unlike the OBR, we believe that GDP will pretty much return to the path seen before the crisis. (See Chart 5.)
  • A more complete recovery in GDP implies that public borrowing will decline quicker than the OBR expects. (See Chart 6.) While the UK is unlikely to follow in the footsteps of the US and unleash another big fiscal stimulus, the extra tax hikes and spending cuts that most fear may not materialise.
  • The strong economic recovery and the unprecedented policy stimulus is a recipe for CPI inflation rising above the 2% target. But although it may pop above 2% later this year, the lagged downward effects of the recession and the strengthening in the pound suggest to us that inflation won’t stay above 2% until late in 2023. (See Chart 7.)
  • While we doubt the Bank of England will announce a new round of quantitative easing (QE) once the current tranche is completed later this year, we think the financial markets are wrong to price in Bank Rate rising from +0.10% before the end of 2022. (See Chart 8.) And even in 2024 when we think CPI inflation will stick above 2%, we suspect the Bank will err on the side of caution and won’t raise rates until 2025.

Overview Charts

Chart 1: First Dose of COVID-19 Vaccines

Chart 2: Monthly Real GDP (% Versus February 2020)

Chart 3: GDP Components (Q4 2019 = 100)

Chart 4: Household Saving & Unemployment Rates (%)

Chart 5: GDP (Q4 2019 = 100)

Chart 6: Public Sector Net Borrowing (£bn)

Chart 7: CPI Inflation (%)

Chart 8: Bank Rate Expectations (%)

Sources: Refinitiv, OBR, gov.uk, Capital Economics


Consumer Spending

Well placed to ramp up spending as restrictions are lifted

  • Consumers are in position to power the recovery as the early signs are that households are willing to go back to pubs and restaurants. In addition, they have enough firepower to finance a spending spree with rising incomes and by saving a smaller share of their income.
  • We think that the early signs that households are willing to go back to pubs and restaurants will mean that the biggest losers of the past year, broadly services for which spending ended last year 15% below their pre-pandemic level (see Chart 9), will enjoy the biggest rebounds in spending over the next two years. More specifically, transport, restaurants and hotels should see the greatest reversal of fortunes. (See Chart 10.)
  • Households are able to fund such a spending spree. Government support measures have protected household incomes and will continue to do so until the furlough scheme ends in September. Nominal disposable income in Q4 2020 was 0.8% higher than a year earlier. (See Chart 11.) And our forecast that real household disposable incomes will rise by 2.7%, 3.0% and 2.7% in 2021, 2022 and 2023 respectively leaves consumers with the ammunition to fund some of the increase in spending.
  • The rest will be financed by households spending a greater share of their incomes after lockdowns forced them to spend a smaller share and save a higher share. Indeed, the stock of excess savings accumulated by households since the pandemic began reached £140bn (6.6% of GDP) by the end of last year. (See Chart 12.)
  • Admittedly, we doubt that households will spend this stock of savings. Most of it is held by higher income households, who tend to spend only a small proportion of their savings. And some households may use it to pay down debt or invest in financial assets or housing. Instead, we assume that households just go back to spending a higher share of their incoming income and saving a smaller share. In other words, the saving rate gradually falls from 16% in Q4 close to the long-run average of 8% by the end of 2023.
  • If households went further and spent some of their stock of savings, then consumer spending would be even stronger. For example, if they spent their entire stock of savings over one year, the saving rate would fall to -1% by Q4 2021 and consumer spending would rise by an extra 11.3%, which would be enough to boost GDP by 6.6%. (See Chart 13.)
  • Our forecast is consistent with the saving rate falling back towards the pre-pandemic level more quickly than it did after the GFC. Back then, the unemployment rate stayed high for four years and the housing market was weak, both of which incentivised saving. This time, we expect the unemployment rate to fall more quickly. (See Chart 14.) And the extension to reduced rates of stamp duty in March’s Budget should continue to support the housing market and spending on household goods. (See Chart 15.) A fall in the saving rate back to its pre-pandemic level implies that the pandemic won’t leave a lasting scar on households.
  • Overall, we expect consumer spending to return to its pre-pandemic level in Q1 2022 and to grow by 4.7%, 8.6% and 3.7% in 2021, 2022 and 2023 respectively. While those growth rates would be broadly similar to those of business investment, households will be the driving force behind the recovery in GDP. (See Chart 16.)

Consumer Spending Charts

Chart 9: Consumer Spending (Q4 2019 = 100)

Chart 10: Consumer Spending, Q4 2020 (% vs Q4 2019)

Chart 11: Nominal Household Income & Spending (£bn)

Chart 12: “Excess” Household Saving (£bn)

Chart 13: Nominal Consumer Spending (Q4 2019 = 100)

Chart 14: Household Saving Rate & Unemployment Rate

Chart 15: Housing Transactions &
Consumer Spending on Household Goods (%y/y)

Chart 16: Contributions to %y/y GDP (ppts)

Sources: Refinitiv, Capital Economics


Investment

Jump in investment reduces likelihood of scarring

  • Rather than lagging behind as we had previously thought, we now believe that business investment will keep pace with the broader economic recovery over the next two years. This would make it even less likely that there will be significant economic scarring from the pandemic.
  • The large revisions for 2020 mean that since mid-November (when the first estimate of Q3 GDP was released) business investment has gone from being 20% below its pre-crisis level and lagging well behind the overall economy to just 7% below its pre-crisis level and in line with GDP. (See Chart 17.)
  • This faster recovery in business investment has been pretty broad based. But it has been especially strong for transport equipment, which was 10% higher in Q4 2020 than in Q4 2019. (See Chart 18.) In fact, the only part of business investment which was below its pre-crisis peak in Q4 2020 was non-residential buildings. This will probably last as many firms continue to re-evaluate the amount of office space they need due to home-working.
  • What’s more, surveys of their intentions suggest that firms probably ramped up investment even further in Q1 2021 as they prepared for the economy to reopen. (See Chart 19.)
  • And the “super deduction” policy announced in the March Budget, which allows firms to deduct 130% of the cost of investment from their tax bill, should encourage firms to continue investing over the next few years. Investment will probably then fall back a bit in 2023 when the policy ends.
  • Firms should be able to finance this investment. Non-financial firms have built up an extra £130bn of cash since the start of 2020 – only a bit less than households. (See Chart 20.)
  • The strong recovery in business investment is especially important because it suggests that the long-term damage to the capital stock and the economy’s future level and rate of GDP growth may be even smaller than we had anticipated.
  • There was significant economic scarring after the GFC partly because business investment didn’t get back to its pre-crisis level for five years. In contrast, this time business investment will probably return to its pre-crisis level by mid-2022 – only two-and-a-half year after the start of the crisis. (See Chart 21.)
  • Residential investment will probably remain fairly strong too. The extension of the stamp duty holiday to the end of September in the Budget has given housing demand another boost. Residential investment is already 2% above its pre-crisis level. Admittedly, our forecast for housing starts implies flat residential investment. But the booming renovation market should ensure that residential investment continues to edge higher. (See Chart 22.)
  • In addition, in the Budget the government renewed its commitment to raising public investment over the next few years as part of its aim to “level up” the regions. As a result, we expect growth in public investment to rise from 3.5% in 2020 to a whopping 18.3% in 2021. That would be its fastest rate since 2006. We then think it will slow to its 10-year average of about 2% by 2023.
  • Overall, we expect all major categories of investment to be very strong over the next couple of years. (See Chart 23.) As a result, investment will contribute to the economic recovery. (See Chart 24.)

Investment Charts

Chart 17: GDP & Business Investment (Q4 2019 = 100)

Chart 18: Investment (Q4 2019 = 100)

Chart 19: CBI Investment Intentions & Business Investment

Chart 20: M4 Money Holdings (£bn)

Chart 21: Business Investment (Start of Recession = 100)

Chart 22: Housing Starts & Residential Investment

Chart 23: Real Investment (Q4 2019 = 100)

Chart 24: GDP (Q4 2019 = 100)

Sources: Refinitiv, Capital Economics


External Demand

Net trade will be a headwind to growth this year

  • A more rapid recovery in GDP in the UK than in the euro-zone means that UK imports are likely to recover more quickly than exports. As a result, net trade will probably be a drag on GDP growth in 2021. But that headwind will change into a tailwind in 2022 as the recovery in the euro-zone catches up.
  • There are three reasons why we think the upturn in exports will lag behind the broader economic recovery. First, the economic recovery in the euro-zone, which buys almost half of UK exports, will take longer than the UK recovery. This means that demand for UK exports might be relatively subdued in 2021, before recovering more quickly in 2022. (See Chart 25.)
  • Second, the end of the Brexit transition period has caused some issues that will probably continue to hold back exports in the first half of this year. Indeed, the volume of UK goods exports to the EU fell by 43.1% m/m in January. And even after rebounding by 48.3% m/m in February, they were still 13% below pre-pandemic levels. (See Chart 26.)
  • Third, there has been little progress between the UK and the EU on “equivalence” for financial services. This doesn’t mean London will no longer be a major financial centre. But it does suggest 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 27.)
  • Admittedly, the trade balance may benefit from continued restrictions on travel. UK residents usually spend more money abroad (travel imports) than foreign visitors do here (travel exports), which means the UK usually runs a consistent travel deficit of about 0.7% of GDP. By the end of 2020, this had switched to a surplus of 0.4% of GDP. (See Chart 28.) And even if travel restrictions are eased later in the summer, it would probably only allow a fraction of the normal summer travel.
  • But more importantly, the strong recovery in domestic demand we envisage suggests that UK total imports will rise by more than exports. (See Chart 29.) Indeed, our positive outlook for investment, which is especially import intensive, means that import growth may be stronger than domestic demand in 2022.
  • As a result, we think that the trade deficit will widen from 0.4% of GDP in 2020 to 2.3% of GDP in 2021. (See Chart 30.) That would be consistent with net trade subtracting 2.1ppts from GDP growth in 2021. But the trade deficit should narrow thereafter as exports catch up.
  • The current account will probably move in the same direction as changes in the primary and secondary income deficits broadly offset each other. We expect UK assets to outperform other developed markets over the next year or so, which might cause the UK’s deficit in income flows (“primary income”) to increase. But the cut in the UK’s foreign aid budget and, from 2022, the reduction in payments to the EU as part of the Brexit financial settlement mean the secondary income deficit should shrink.
  • Overall, we expect the current account deficit to narrow from 4.5% of GDP in 2021 to 3.0% in 2023. That would leave it pretty much at pre-COVID and pre-Brexit levels. (See Chart 31.) That would be consistent with the spike in the net borrowing of the public sector unwinding a bit quicker than the spike in net lending of households. (See Chart 32.)

External Demand Charts

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

Chart 26: Trade in Goods (Values, Exc. Erratics, £bn)

Chart 27: Trade in Services Balance (As a % of GDP)

Chart 28: Trade in Travel Services (As a % of GDP)

Chart 29: Domestic Demand & Imports (Q4 2019 = 100)

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

Employment not far off its low point

  • We expect the unemployment rate to rise to a peak of just over 6.0% in early 2022, but that would be a better result than most feared even only a few months ago. And our view that the economy will escape the crisis without much long-term scarring suggests that by the end of 2023, the unemployment rate may be only a little above its pre-pandemic level of 4.0%.
  • The fact that employment has stayed so high given the collapse in GDP in 2020 highlights the extent to which the furlough scheme has protected jobs. In January, the economy was 7.9% smaller than before the crisis and the total number of hours worked was 8.0% lower. But employment was just 2.1% lower.
  • We think that the bulk of the falls in employment are now in the past. By the time the furlough scheme ends on 30th September, the economy is likely to be strong enough to support a level of employment not far off where it is now. (See Chart 33.) And the sharp rise in the survey measures of hiring intentions suggests that employers are increasingly confident about the future. (See Chart 34.)
  • Admittedly, the LFS measure of employment may not have captured the full extent of the fall. HMRC data taken from company payrolls suggest that at its low point employment had fallen by a bigger 3.1%. (See Chart 35.)
  • What’s more, there may still be some shake-out in employment once the furlough scheme ends. 4.8 million people were furloughed in February and some of their jobs will disappear. As about 40% of those still on furlough in February were under the age of 34, there will probably be more dislocation for younger age groups. So we still expect the 2.1% fall in LFS employment to turn into a 2.4% fall by October. That would be a total fall from its peak of 803,000.
  • Moreover, the stability of the unemployment rate over the past year has only been possible due to 616,000 people leaving the labour force. Some of them will probably return and actively search for work again as the economy recovers. But as many may find it hard to land a job quickly, they will add to unemployment.
  • The net effect is a further rise in unemployment of 425,000 by the end of 2021. That would push up the jobless rate from 5.0% in January to just over 6.0% in early 2022. That would be below the peak of 6.5% the OBR expects and the high of 8.5% after the GFC. (See Chart 36.)
  • Employment is likely to recover more quickly than after previous recessions too. (See Chart 37.) That adds to our view that the economy’s potential won’t be permanently damaged by the crisis. Beyond September, we expect employment to spring back alongside the recovery in GDP and the jobless rate to drop to just above 4.0% by the end of 2023.
  • That said, even as GDP recovers labour market slack will keep pay growth subdued for a couple of years yet. Our “broad unemployment rate” suggests there is as much slack now as if the unemployment rate were 12%. (See Chart 38.) Admittedly, we expect pay growth to climb from 4.8% in January to a peak of 8.4% in June. It will be boosted by the current level of earnings being compared to the low points in April and May 2020 and compositional effects from many lower-paid workers losing their jobs. (See Chart 39.)
  • But as these effects fade, earnings growth may drop back to 1.6% in 2022. (See Chart 40.) And it is not until the end of 2023 that we think labour costs will rise more rapidly and have a more persistent upward influence on inflation.

Labour Market Charts

Chart 33: Employment & GDP

Chart 34: KPMG/REC Survey & Employment

Chart 35: Employment (Millions)

Chart 36: ILO Unemployment Rate (%)

Chart 37: Change in LFS Employment (100 = Pre-Crisis Peak)

Chart 38: Unemployment (% of Workforce)

Chart 39: Average Earnings Growth

Chart 40: Total Average Earnings (%3myy)

Sources: Refinitiv, ONS, UK Government, Capital Economics


Inflation

Recovery won’t push inflation “sustainably” above 2% until 2023

  • CPI inflation is on the cusp of rebounding to above 2.0% by the end of the year. But the recovery from the COVID-19 crisis may not keep core inflation persistently above 2.0% until late 2023, although there is a risk that it happens sooner.
  • While the drags from lockdowns and falls in fuel/utilities prices have kept CPI inflation subdued over the past year, inflation is on the cusp of rebounding. Recent rises in fuel and utilities prices mean that they will soon switch from being a drag on inflation to boosting it. (See Chart 41.)
  • Petrol and diesel prices have already risen from the lows of £1.10 per litre reached after the sharp fall in oil prices in April last year to £1.28 per litre now. (See Chart 42.) Our forecast that oil prices will climb from $63pb now to $70pb by the end of 2021 suggests that fuel prices won’t climb much further. Even so, fuel price inflation will jump to about 13% in April and add 0.3-0.4ppts to CPI inflation.
  • And the 9.2% rise in Ofgem’s energy price cap on 1st April should mean that utility price inflation climbs from -8.4% in January to around +2.7% in April. Moreover, since utility prices fell in October 2020, utility price inflation will take an additional step up in October 2021, contributing 0.3ppts to overall inflation. (See Chart 43.) All this will be enough to raise CPI inflation to 2.1% in December.
  • However, core inflation, which excludes these energy effects and sends a clearer signal of whether trends are transitory or lasting, will stay below 2.0%. And several factors will suppress both overall and core inflation in 2022.
  • We forecast that a rise in the supply of oil in 2021 will cause oil prices to fall from $70pb to $60pb at the end of 2022, resulting in fuel inflation subtracting 0.2ppts from CPI inflation in December 2022. And by reducing the cost of imported goods, the stronger pound will subtract about 1ppt in 2022. (See Chart 44.)
  • We also expect the lagged effect of spare capacity caused by the recession to weigh on core inflation for a while yet. (See Chart 45.) But as the recovery reduces the spare capacity, this effect will start to add to inflation. We think it could add about 0.5ppts to core inflation in late 2023, which would take core inflation above 2.0%. That rise would be driven by the kind of trend that the Bank would consider sustainable.
  • What’s more, most of the risks to our inflation forecasts in 2021 and 2022 lie on the upside. We are not too concerned by Brexit-related issues or the recent surge in global shipping costs. Brexit-related costs should be cushioned by the effect of the stronger pound. And while the rise in shipping costs is consistent with core goods inflation surging (see Chart 46), it’s only about 6% of the CPI that is direct exposed to higher shipping costs.
  • Instead, the main upside risk comes from spare capacity effects biting sooner and their upward influence being bigger than we expect. Indeed, the huge loosening in both monetary and fiscal policy has boosted the money holdings of those most likely to spend it. (See Chart 47.) So when spare capacity does begin to bite, its upward influence could be strong.
  • Overall, we expect CPI inflation to rise to around 2.1% by December 2021. But we don’t think that overall CPI inflation and core inflation will be “sustainably” above 2.0% until 2023 or 2024. (See Chart 48.)

Inflation Charts

Chart 41: Contributions to CPI Inflation (ppts)

Chart 42: Oil & Fuel Prices

Chart 43: Wholesale & Consumer Utility Prices

Chart 44: Effect of the Pound on Inflation (ppts)

Chart 45: Core CPI Inflation (%)

Chart 46: Shipping Costs & Core Goods CPI

Chart 47: M4 Money Holdings (£bn)

Chart 48: CPI & Core Inflation (%)

Sources: Refinitiv, Capital Economics


Monetary & Fiscal Policy

A further fiscal consolidation to be avoided

  • We don’t expect interest rates to rise above +0.10% before 2025. Meanwhile, if we are right in thinking that the recovery will be faster and fuller than the OBR expects, then further major tax hikes or spending cuts may not be needed to reduce the public deficit.
  • The markets have come round to our view that the Bank of England won’t implement negative interest rates this year. We doubt it will raise its QE target above £895bn once it has completed its announced purchases at the end of this year either. (See Chart 49.)
  • But we think the markets are wrong to price in interest rates rising from +0.10% before the end of 2022. (See Chart 50.) We don’t expect inflation to stay above the 2% target until late in 2023. And even than as the Bank wants to see inflation “sustainably” above the 2% target, it is unlikely to rush into raising rates. That may mean rates stay at +0.10% until 2025.
  • Even so, higher government bond yields in the US and concerns about rising domestic inflation further ahead may cause 10-year gilt yields to rise from 0.80% now to 1.25% by the end of 2021 and to 1.50% by the end of 2022. (See Chart 51.) And while we doubt the pound will rise much further against the dollar, we think there is more scope for it to strengthen against the euro due to an increase in relative bond yields and growing expectations of a faster economic recovery in the UK. (See Chart 52.)
  • Meanwhile, the extension of many of the existing fiscal support schemes means that fiscal policy shouldn’t damage the economic recovery much this year. They bring the cost of the government’s direct policy support to £345bn (16.5% of GDP) in total in 2020/21 and 2021/22. So after reaching about £325bn (15.5% of GDP) in 2020/21, we expect the deficit to stay elevated at £230bn (10.1% of GDP) in 2021/22.
  • But the £36.2bn (1.7% of GDP) of tax hikes and spending cuts from 2023 announced in March’s Budget caused the OBR to lower its forecast for the current budget deficit (which excludes investment) from £27bn to just £0.9bn in 2025/26. (See Chart 53.) So on this definition of “balancing the books”, the fiscal hole created by the crisis has already been filled. That means the Chancellor won’t need to announce further tax hikes or spending cuts to reduce the deficit.
  • What’s more, if we are right in thinking that the economic forecasts made by the OBR will prove to be overly pessimistic, then the budget deficit could fall more quickly. (See Chart 54.) That may mean the Chancellor could cancel/reverse some of the proposed tax hikes before the 2024 general election.
  • Admittedly, this won’t be enough to return the debt to GDP ratio to pre-virus levels by 2025/26. (See Chart 55.) And the government’s debt servicing costs are now twice as sensitive to higher interest rates than before the crisis. That’s largely due to the Bank’s QE, which has shortened the effective median maturity of public debt from more than ten years before the GFC to less than four years now. (See Chart 56.)
  • But our forecast that the Bank won’t raise rates until 2025 means the Chancellor has time to think of ways to reduce the sensitivity of debt to interest rates. That would buy more time for the debt to GDP ratio to be reduced by GDP rising rather than a further bout of tax hikes or spending cuts.

Monetary & Fiscal Policy Charts

Chart 49: Bank of England Quantitative Easing (£bn)

Chart 50: Bank Rate Expectations (%)

Chart 51: Bank Rate & Gilt Yields (%)

Chart 52: Pound Exchange Rates

Chart 53: Current Budget Balance in 2025/26 (£bn)

Chart 54: Public Sector Net Borrowing (£bn)

Chart 55: Public Sector Net Debt (% of GDP)

Chart 56: Mean & Median Maturity of Gilts (Years)

Sources: Refinitiv, OBR, Bank of England, 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 core inflation below the Bank of England’s 2% target for CPI inflation 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 from 2023/24.
  • 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

-0.7

3.9

1.9

1.7

Real consumption

0.4

2.0

-0.7

4.4

2.3

1.9

Productivity

0.3

0.6

-1.6

3.2

1.5

1.4

Employment

0.3

1.4

0.9

0.7

0.4

0.3

Unemployment rate (%, end of period)

7.9

5.4

4.5

4.1

3.5

4.0

Wages

3.0

1.6

2.6

3.0

3.7

4.1

Inflation (%)

2.7

2.3

1.7

1.6

2.2

2.6

Policy interest rate (%, end of period)

0.50

0.50

0.10

0.30

1.00

2.75

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

3.51

1.96

0.24

1.25

1.75

3.75

Government budget balance (% of GDP)

-7.0

-4.6

-5.2

-4.5

-3.9

-4.3

Gross government debt (% of GDP)

69.7

82.3

100.9

98.5

97.7

100.0

Current account (% of GDP)

-3.3

-4.0

-3.9

-3.2

-1.7

-4.1

Nominal GDP ($bn)

1,606

1,920

2,112

2,706

3,348

7,885

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
Kieran Tompkins, Assistant Economist, kieran.tompkins@capitaleconomics.com
Oliver Byrne, Research Assistant, oliver.byrne@capitaleconomics.com