Turning the corner - Capital Economics
UK Economics

Turning the corner

UK Economic Outlook
Written by Paul Dales
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We think the economy has turned a corner and that GDP growth will beat the consensus forecast by accelerating from 1.0% this year to 1.8% next year. Of course, the lingering uncertainty over the UK’s future relationship with the EU will hold back business investment this year. But if we are right in assuming that the UK and the EU will take steps to prevent a disruptive change in their relationship on 31st December 2020, then business investment should strengthen next year. And we think that a loosening in fiscal policy worth up to 1% of GDP will soon start to boost GDP growth. While there remains a chance that interest rates will be cut this year, we think it is more likely that the markets are caught out by rates being left at 0.75% this year and being increased to 1.00% in 2021.

  • Overview – We think the economy has turned a corner and that GDP growth will beat the consensus forecast by accelerating from 1.0% this year to 1.8% next year. Of course, the lingering uncertainty over the UK’s future relationship with the EU will hold back business investment this year. But if we are right in assuming that the UK and the EU will take steps to prevent a disruptive change in their relationship on 31st December 2020, then business investment should strengthen next year. And we think that a loosening in fiscal policy worth up to 1% of GDP will soon start to boost GDP growth. While there remains a chance that interest rates will be cut this year, we think it is more likely that the markets are caught out by rates being left at 0.75% this year and being increased to 1.00% in 2021.
  • Forecasts – Our forecasts are based on the UK and the EU agreeing some sort of fudge that means there is not a step change in their relationship at the end of this year.
  • External Demand – Net trade will probably remain a drag on GDP growth, due to soft overseas demand restraining export growth this year and stronger domestic demand boosting import growth in 2021.
  • Consumer Spending – A rise in the willingness of households to spend could result in the growth of household spending accelerating from 1.2% last year to 1.5% in 2020 and to 1.6% in 2021.
  • Investment – Business investment is unlikely to rise much until Brexit uncertainty fades further. But the government’s plans to raise public investment will boost GDP growth later this year and in 2021.
  • Labour Market – Although we expect both employment growth and wage growth to slow this year, we doubt that the labour market will significantly restrain economic growth.
  • Inflation – While looser fiscal policy will boost economic growth, we don’t think it will do much more than raise CPI inflation closer to the 2% target.
  • Monetary & Fiscal Policy – Fiscal policy will shift from being a drag on GDP growth to boosting it. That’s one reason why we think the next move in interest rates will probably be up, albeit not until 2021.
  • Long-term Outlook – We suspect that a lot of the drag on the UK’s long-term rate of economic growth from Brexit will be cushioned by a rise in productivity growth triggered by the digital revolution.

Key Forecasts Table

Table 1: Key Forecasts*

 

2019

2020

2021

Annual (% y/y)

 

Q4f

Q1f

Q2f

Q3f

Q4f

Q1f

Q2f

Q3f

Q4f

Average 2010-17

2018

2019f

2020f

2021f

Demand (% q/q)

              

GDP

-0.1

0.2

0.4

0.5

0.5

0.4

0.4

0.4

0.4

2.0

1.3

1.3

1.0

1.8

Consumer Spending

0.0

0.5

0.5

0.5

0.4

0.3

0.3

0.3

0.3

2.2

1.6

1.2

1.5

1.6

Government Consumption

0.5

1.0

1.1

1.3

1.0

0.2

0.2

0.2

0.2

0.9

0.4

2.9

3.0

2.3

Fixed Investment

-0.3

0.2

1.1

1.3

1.3

0.9

0.6

0.6

0.6

2.9

-0.2

0.7

1.8

3.7

Business Investment

-0.5

0.0

0.5

0.8

0.7

0.7

0.5

0.5

0.5

4.3

-1.5

-0.1

0.5

2.5

Stockbuilding1 (contribution, ppts)

0.2

0.5

0.0

0.0

0.0

0.0

0.0

0.0

0.0

0.1

0.2

-0.1

-0.2

0.0

Domestic Demand2

-0.6

2.3

0.7

0.8

0.7

0.4

0.4

0.4

0.4

2.1

1.3

1.3

1.4

2.0

Exports

1.7

-5.5

0.1

0.0

0.2

0.6

0.6

0.7

0.7

3.6

1.2

2.3

-1.5

1.8

Imports

-0.1

1.3

1.0

1.0

0.7

0.6

0.5

0.4

0.5

4.0

2.0

3.0

-0.5

2.6

Net Trade2 (contribution, ppts)

0.5

-2.1

-0.3

-0.3

-0.2

0.0

0.0

0.1

0.1

0.0

-0.2

-0.2

-0.3

-0.3

Labour Market (% y/y)

 

   

 

   

 

     

Unemployment (ILO measure, %)

3.9

4.0

4.0

3.9

3.9

3.9

3.8

3.8

3.8

6.6

4.1

3.9

3.9

3.8

Employment

0.8

0.4

0.1

0.5

0.3

0.6

0.6

0.6

0.6

1.2

1.2

1.0

0.3

0.6

Productivity (output per hour)

-0.4

0.3

0.6

0.6

1.4

1.3

1.2

1.2

1.1

0.5

0.5

-0.2

0.7

1.2

Income & Saving (%y/y)

 

   

 

   

 

     

Nominal Average Weekly Earnings3

3.1

3.3

2.9

3.0

3.0

3.3

3.2

3.3

3.4

1.9

2.9

3.5

3.1

3.3

Real Average Weekly Earnings4

1.6

1.6

1.4

1.6

1.5

1.6

1.7

1.6

1.5

-0.4

0.4

1.6

1.5

1.6

Real Household Disposable Income

0.2

0.4

2.0

2.6

1.8

1.6

2.1

1.9

1.7

1.7

2.5

1.0

1.7

1.8

Saving Ratio (%)

5.8

5.1

6.9

6.4

5.8

4.9

7.3

6.9

6.1

8.8

5.8

5.7

6.0

6.3

Prices (% y/y)

              

CPI

1.4

1.9

1.4

1.3

1.6

1.6

1.7

1.8

1.9

2.3

2.5

1.8

1.6

1.7

Core CPI5

1.6

1.7

1.8

1.7

1.8

1.8

1.8

1.9

2.0

2.1

2.1

1.7

1.7

1.9

CPIH

1.4

1.8

1.5

1.4

1.8

1.8

1.8

1.9

2.1

2.1

2.3

1.7

1.6

1.9

RPI

2.2

2.5

1.9

1.8

2.1

2.1

2.3

2.6

2.7

3.1

3.3

2.6

2.1

2.4

RPIX

2.2

2.6

2.1

2.0

2.3

2.3

2.3

2.4

2.6

3.2

3.4

2.5

2.3

2.4

Nationwide House Prices (end period)

1.4

1.4

1.6

1.8

1.5

1.7

1.8

1.9

2.0

3.8

0.5

1.4

1.5

2.0

Monetary Indicators (end period)

 

   

 

   

 

     

Bank Rate (%)

0.75

0.75

0.75

0.75

0.75

0.75

1.00

1.00

1.00

0.46

0.75

0.75

0.75

1.00

10-Year Gilt Yield (%)

0.82

0.87

0.91

0.96

1.00

1.06

1.13

1.19

1.25

2.17

1.28

0.82

1.00

1.25

Sterling Trade-weighted Index

80.7

81.3

82.9

84.6

86.4

87.1

87.8

88.5

89.1

82.9

77.0

80.7

86.4

89.1

$/£

1.33

1.31

1.33

1.34

1.35

1.36

1.38

1.39

1.40

1.52

1.28

1.33

1.35

1.40

Euro/£

1.18

1.20

1.23

1.26

1.29

1.30

1.31

1.32

1.33

1.22

1.11

1.18

1.29

1.33

Current Account & Public Finances

 

   

 

   

 

     

Current Account (£bn)

-8

-15

-20

-22

-23

-22

-21

-21

-21

-73

-83

-85

-80

-85

% of GDP

-1.4

-2.6

-3.6

-3.6

-3.8

-3.7

-3.7

-3.7

-3.7

-3.9

-3.9

-3.8

-3.4

-3.7

PSNB6 (£bn, financial year)

98

38

43

68

70

% of GDP (financial year)

5.5

1.8

1.9

3.0

2.9

Global (% y/y)

 

   

 

   

 

     

World GDP7(CE estimate for China)

2.7

3.0

3.0

3.0

3.2

3.2

3.3

3.4

3.3

3.6

3.6

2.9

2.9

3.2

Oil Price (Brent, $pb, end period)

66

65

68

70

75

75

76

77

78

81

54

66

75

78

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 the UK and the EU agree some kind of fudge that means there is not a big step change in their relationship on 31st December 2020.


Overview

Fiscal policy to the rescue

  • The outlook for the economy is a bit rosier than most appreciate. We think that GDP growth will beat the consensus forecast by rising from 1.0% this year to 1.8% next year and that the markets will be caught out by interest rates in 2021 being higher than they expect.
  • By reducing uncertainty and ruling out a no deal Brexit on 31st January 2020, December’s decisive election result marked a turning point for the economy. The resulting rebound in the activity surveys suggests that GDP will rise in Q1 of this year after it probably fell by 0.1% q/q in Q4 of last year. (See Chart 1.)
  • Admittedly, business investment probably won’t rise much this year. The negotiations over the future UK-EU relationship will be tough and will probably last right until the 31st December 2020 deadline. The risk of no agreement being reached and the UK trading with the EU on WTO terms from 2021, which would be similar to a no deal, will linger large.
  • While we think that the chances of a full agreement or no agreement at all by the end of the year are both substantial, the most likely outcome is some kind of fudge that prevents a step change in trading rules. This could be a piecemeal approach in which deals in some areas (goods) are agreed this year but the status quo is kept in other areas (services) until deals can be reached after 2020.
  • Uncertainty could then ease further in 2021 as something like a no deal on 31st December 2020 is avoided and the new UK-EU relationship starts to fall into place. The 2.5% rise in business investment we expect in 2021 wouldn’t be large by historical standards, but it could be the start of a new trend. (See Chart 2.)
  • Instead, the main driver of the acceleration in the quarterly rate of GDP growth we expect this year will be a further loosening in fiscal policy. The extra government spending announced in September will probably boost GDP growth by 0.4% from the start of the 2020/21 financial year in April. (See Chart 3.)
  • And we estimate that the new fiscal rules will allow the Chancellor to raise public investment in the Budget on 11th March by an extra 0.5% of GDP. So the economy may soon get a fiscal boost worth almost 1% of GDP. (See Chart 4.)
  • The annual growth rate of GDP may still be just 1.0% this year. But some modest improvement in the global backdrop and a reduction in Brexit uncertainty, which boosts both investment and household spending, should allow GDP growth to rise to 1.8% in 2021. (See Chart 5.)
  • While fiscal policy will contribute to faster GDP growth, we don’t expect it to do more than help raise CPI inflation to the 2.0% target. (See Chart 6.) The Trump fiscal stimulus in the US in 2018 happened at a similar stage of the cycle and hardly boosted inflation at all. (See Chart 7.)
  • So while we doubt that the Monetary Policy Committee (MPC) will need to lower interest rates from 0.75%, we are not expecting the Committee to raise rates rapidly either.
  • We expect that rates will stay at 0.75% for all of this year and that they will rise to just 1.00% next year. Even so, that would catch out the financial markets as they have assumed that at the end of both this year and next interest rates will be below 0.75%. (See Chart 8.)

Overview Charts

Chart 1: IHS Markit/CIPS Composite PMI & GDP

Chart 2: Business Investment & Uncertainty

Chart 3: GDP

Chart 4: Chge in Cyclically-Adj. Budget Deficit (% GDP)

Chart 5: GDP Forecasts (% y/y)

Chart 6: CPI Inflation (%)

Chart 7: US GDP & Inflation (%)

Chart 8: Expectations for Interest Rates (%)

 

Sources: Refinitiv, IHS Markit, Bloomberg, Capital Economics


External Demand

Net trade to remain a drag

  • The external sector will remain a drag on the economy this year due to soft global demand. And even as the global economy improves in 2021, net trade will continue to weigh on GDP growth due to strengthening domestic demand.
  • All the evidence points to exports continuing to struggle in 2020. Admittedly, they were on an upward trajectory in the second half of 2019. But that was partly due to overseas firms stockpiling UK goods in case there was a no deal Brexit in October or January. (See Chart 9.) Surveys of export orders offer a better guide to foreign demand and suggest export growth will slow this year. (See Chart 10.)
  • We think global GDP growth will bottom out in Q1. But the recovery will be slow. And importantly for the UK, we think that the euro-zone will lag behind and grow by just 0.7% in 2020, down from 1.2% in 2019. Aggregate growth in the UK’s trade partners will therefore restrain export growth until things improve in 2021. (See Chart 11.)
  • Uncertainty about UK-EU trade arrangements after 31st December 2020 may be starting to restrain exports too. This and weak demand on the continent may explain the divergence between exports to the EU and exports to the rest of the world in 2019. (See Chart 12.)
  • What’s more, our forecast that the pound will strengthen over the next two years will exacerbate the impact of soft external demand. (See Chart 13.)
  • The consequences of the transition period ending before a trade deal is struck might not be as severe as most think. Trade would probably be disrupted temporarily as new border processes bed down. But judging by the large amount of services the EU imports from countries with which it doesn’t have any trade agreement, the UK will probably continue to run a large services trade surplus with the euro-zone. (See Chart 14.)
  • At the same time as export growth slows, there are two reasons why import growth is likely to strengthen. First, the flip side of the stronger pound is that imports become more attractive relative to domestically produced goods. Second, improved sentiment since the election and the impending fiscal stimulus mean we expect domestic demand to support import growth. (See Chart 15.)
  • Pulling this together, we think that net trade will knock 0.3ppts off growth in 2020. And while global growth and export growth should pick up some steam in 2021, strong domestic demand is likely to mean net trade remains a drag. (See Chart 16.)
  • The recent surplus in the trade balance is due to distortions to trade from Brexit deadlines and won’t last. That said, the stronger pound will reduce the cost of imports in sterling terms and mean the trade deficit will be a little smaller than its post-crisis average, perhaps about 1% of GDP in 2021 as opposed to 1.5%. But with the income balance more permanently in negative territory due to a structural deterioration in the UK’s net holdings of overseas assets, the current account deficit will remain fairly close to 4% of GDP in 2021.
  • As the deficit has been funded by inflows of capital from abroad of late, the pound looks set to remain vulnerable to a big shift in sentiment, although we are not expecting one.

External Demand Charts

Chart 9: Export & Import Values (£bn)

Chart 10: Surveys & Goods Export Volumes

Chart 11: Trade Partner GDP & UK Exports (% y/y)

Chart 12: Goods Exports (Current Prices, EU Ref.=100)

Chart 13: Trade-Weighted Sterling & Exports (% y/y)

Chart 14: EU Ex. UK Services Imports (2018, % of Total)

Chart 15: Domestic Demand & Imports (% y/y)

Chart 16: Net Trade Contribution to y/y GDP (ppts)

 

Sources: Refinitiv, IHS Markit, CBI, BoE, Capital Economics


Consumer Spending

Households set to loosen their purse strings

  • Consumer spending growth is likely to rebound this year as households become more willing to spend. However, a slowdown in employment and earnings growth as well as lingering Brexit uncertainty mean that spending is probably not going to soar.
  • The slowdown in consumer spending growth at the end of last year, from +0.3% q/q in Q3 to a likely 0.0% in Q4, seems like a temporary blip brought on by fears about the election result and a no deal Brexit. (See Chart 17.) Given that income growth remains strong (we estimate that real household disposable incomes rose by 0.2% q/q in Q4) it seems that it is consumers’ willingness to spend that has been the key constraint on growth, not their ability to spend.
  • Indeed, households have been building up their precautionary savings for a while. The saving ratio has risen from just less than 4.0% at the start of 2017 to 5.4% in Q3 and we expect it rose to almost 6% in Q4. (See Chart 18.)
  • But with the prospects of higher taxes under a Labour government and a no deal Brexit on 31st January off the table, households might now be willing to spend more. There may be a bounce in consumer sentiment in January, which has fallen well below the so-called misery index (the sum of the unemployment rate and inflation) would suggest. (See Chart 19.)
  • This improvement in sentiment has already started coming through in the housing market, which is one of the areas of the economy most susceptible to sentiment. The number of surveyors who expect a rise in house sales surged in December. (See Chart 20.) Of course, house prices are still very high relative to incomes, so we do not expect them to surge. But we are expecting modest rises in prices of 1.5% this year and 2.0% in 2021.
  • Admittedly, Brexit uncertainty will linger and could start to intensify later this year. What’s more, a slowdown in employment and wage growth will eat into real household disposable income. However, we don’t think that real wages will slow to the extent that they pull down spending growth. (See Chart 21.)
  • Indeed, low inflation means that, despite the slowdown in nominal earnings growth, real earnings growth is likely to still be pretty strong. (See Chart 22.)
  • At the same time, the drag on real household disposable income in 2019 from “other income”, which consists of things like earnings from private pensions and social benefits, is unlikely to be repeated in 2020. As a result, we think that real income growth will rise from 1.0% in 2019 to 1.7% in 2020. (See Chart 23.)
  • Households are likely to spend at some of this extra income. We expect consumer spending growth to rise from 1.2% in 2019 to 1.5% in 2020 and to 1.6% in 2021. (See Chart 24.)
  • Overall, while consumer spending has been subdued recently, rising income growth means there is scope for household spending growth to accelerate. And if consumer confidence jumps over the next few months in the same way that business confidence has, consumers might spend more of their income. Lingering Brexit uncertainty, however, will prevent consumer spending growth from surging.

Consumer Spending Charts

Chart 17: Consumer Spending

Chart 18: Household Saving (% of Disposable Income)

Chart 19: Misery Index & Consumer Confidence

Chart 20: Surveyors Expecting a Rise in Housing Sales
(% Balance)

Chart 21: Total Real Pay & Spending (% y/y)

Chart 22: Average Weekly Earnings & Inflation

Chart 23: Contribution to % y/y RHDI (ppts)

Chart 24: RHDI & Household Spending (% y/y)

 

Sources: Refinitiv, RICS, Capital Economics


Investment

Government to take on the baton

  • Investment will provide crucial support to GDP growth this year as a one-off rise in public investment eclipses weak, albeit stabilising, business investment. A further easing in Brexit uncertainty should allow a more meaningful recovery in business investment to get underway in 2021.
  • The improvement in sentiment since the general election result ruled out a no deal Brexit on 31st January and suggests business investment will stabilise this year after falling in 2018 and 2019.
  • The Bank of England’s Brexit uncertainty index, which tracks the proportion of firms that name Brexit as one of their top three sources of concern, fell from 55% in November to 49% after the election. (See Chart 25.) Moreover, the CBI’s measure of investment intentions surged in January, so investment might have reached a turning point. (See Chart 26.)
  • That said, we don’t expect the annual growth rate of business investment to suddenly return to the pre-referendum norm of 5% or so. Investment intentions may be reined in again as firms worry about what sort of trade deal will be agreed with the EU (if any) by the end of the transition period on 31st December 2020.
  • Moreover, the combination of strong growth in labour costs and a reluctance to raise prices has squeezed firms’ margins and reduced the cash available for investment. (See Chart 27.) And the slowdown in economic growth last year has eased capacity constraints and reduced the urgency to invest. (See Chart 28.)
  • As a result, we expect business investment to rise by only 0.5% this year. But if the UK and the EU reach an agreement that prevents disruption to trade at the end of 2020, a more meaningful recovery should take shape in 2021. We have pencilled in a 2.5% rise in business investment in 2021. (See Chart 29.)
  • Meanwhile, the surveys suggest that housing market sentiment has improved since the election, which could lead to some pick up in housing demand. As a result, residential investment could regain some momentum. That said, we are only forecasting a small increase in house prices, which will keep residential investment in check. (See Chart 30.)
  • But the biggest influence on total investment will come from the government. The Chancellor has rewritten the fiscal rules to allow him to invest up to 3% of GDP, up from 2.2% in the current financial year.
  • Given the government’s aim to “level up” the regions and reward new Conservative voting areas, it seems likely this fiscal space will be used to fund infrastructure projects in the Midlands and the North. In the Budget on 11th March we expect an increase in government investment of around £10bn (0.5% of GDP) over and above existing plans to be announced. (See Chart 31.)
  • This rise in government investment is the main reason we think annual growth in total investment will rise from 0.7% last year to 1.8% this year. And in 2021 we suspect a more substantial recovery in business investment will raise total investment growth to almost 4%. Investment will therefore make a sizeable contribution to GDP growth. (See Chart 32.)

Investment Charts

Chart 25: Bank of England Brexit Uncertainty Index

Chart 26: Investment Intentions & Business Investment

Chart 27: Companies’ Rate of Return & Investment

Chart 28: Business Investment & Capacity Constraints

Chart 29: CBI Uncertainty Index & Business Investment

Chart 30: House Prices & Residential Investment (% y/y)

Chart 31: Net Public Sector Investment (% GDP)

Chart 32: Investment Contribution to GDP (y/y, ppts)

 

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


Labour Market

Softening, but unemployment to remain low

  • The labour market is unlikely to offer as much support to the economy over the next two years as it has over the previous two. But we don’t think that it will weaken enough to become a drag on consumer spending.
  • The weakening of the labour market last year is likely to continue over the next two years. Admittedly, most of the downturn in employment growth in the second half of last year was due to fewer people working part-time, which is not necessarily a negative for the economy. (See Chart 33.) But the annual growth rate of full-time employees also dipped. And measures of slack, such as the vacancy ratio, have turned down. (See Chart 34.)
  • We suspect annual employment growth will slow from an average of 1.0% in the second half of 2019 to 0.3% in 2020 before recovering a little to 0.6% 2021. This is partly because the reduction in Brexit uncertainty means that firms may start to invest more in capital to boost output rather than hiring more workers. (See Chart 35.)
  • However, weaker growth in the labour force may make it difficult for employers to find the right employees, especially after the government tightens migration policy in 2021.
  • While the details of the new immigration policy still have to be worked out, the government has pledged to significantly reduce the number of immigrants coming from the EU. This is likely to add to the drag on net migration of a lower pound and weak GDP growth. (See Chart 36.)
  • What’s more, an ageing population will continue to weigh on growth in the labour force. And with the participation rate already high, it doesn’t look like there is much scope for older people to continue to work for longer.
  • Of course, lower net migration will affect some industries more than others. Both the hotels/food services and the transport industries rely heavily on EU workers. And their high vacancy ratios suggests they may already be struggling to find workers. (See Chart 37.) The government has also said that there will be no exemptions for EU workers outside of the agricultural sector.
  • Softer demand for labour and weaker workforce growth will probably mean that the unemployment rate stays pretty close over the next two years to its current 3.8% rate.
  • Nonetheless, wage growth will probably still slow a bit. (See Chart 38.) Some of the latest surveys suggest that it could slow from 3.2% in November to close to 2.0%. (See Chart 39.) But as the current unemployment rate of 3.8% is close to our estimate of the natural rate, we suspect that wage growth it will stay around 3.0% in 2020 and 2021.
  • For that to be sustained, the annual rate of productivity growth will need to rise from just 0.1% in Q3. (See Chart 40.)
  • The upshot is that the recent weakening in employment growth is likely to continue, but softer growth in the workforce means that the unemployment rate will probably stay close to 3.8%. As such, wages growth may not slow that much further.

Labour Market Charts

Chart 33: Change in Employment (000s, 3m/3m)

Chart 34: Measures of Labour Market Tightness

Chart 35: Employment & Business Investment (%y/y)

Chart 36: Relative GDP & EU Migration

Chart 37: Vacancies & Workforce Migration

Chart 38: Employment & Earnings

Chart 39: Private Sector Earnings & REC Salaries Survey

Chart 40: Real Pay & Productivity (% y/y)

 

Sources: Refinitiv, REC, Capital Economics


Inflation

Inflation to remain below target, despite fiscal stimulus

  • Despite the prospect of a decent fiscal stimulus, inflation is likely to spend most of the next two years below its 2% target.
  • Most of the easing in CPI inflation from a recent peak of 2.1% in July 2019 to 1.3% by the end of last year will probably be sustained in 2020. (See Chart 41.)
  • Admittedly, inflation is likely to rise back up to the 2% target briefly in early 2020, partly as the downward influence from soft fuel and utility price pressures in early 2018 drop out of the annual comparison. However, there are three reasons why we think inflation will average just 1.6% this year.
  • First, falling wholesale gas and electricity prices are likely to push down domestic utility prices when the price cap is reviewed in April. (See Chart 42.) Previous declines in agricultural prices will probably lead to a sharp easing in food price inflation too. (See Chart 43.) Together, these forces could knock 0.6ppts off CPI inflation between Q1 2020 and the end of this year.
  • Second, and more importantly, soft consumer demand appears to be forcing retailers to absorb at least part of the rise in wage growth, from just under 2% in early 2017 to around 3.5%, into their profit margins. Indeed, services inflation – a proxy of domestically-generated inflation – has remained close to 2.5%. (See Chart 44.)
  • With Brexit uncertainty likely to continue to restrain demand this year, this squeeze looks set to persist. After all, firms’ margins are pro-cyclical, widening when firms feel demand is robust and narrowing when it is weak. (See Chart 45.)
  • Third, we doubt that the upcoming fiscal stimulus will provide an especially large boost to inflation. After all, the recent softening in activity and fall in investment should mean that there is at least some spare capacity in the economy.
  • That’s the lesson after the Trump stimulus in the US in 2018 too. Core inflation edged up from 1.8% in 2017 to 2.2% in 2018 in the US. But if you take out the dip in inflation in 2017, which was due to a one-off fall in the price of mobile phone contracts, then inflation barely rose at all. (See Chart 46.)
  • Indeed, the structural factors that have held down inflation in the US and in most other major advanced countries – such as low inflation expectations, demographics, technological progress and weak labour bargaining power – are all also present in the UK. And in most countries a pick-up in inflation to typical target rates of 2% has remained elusive. (See Chart 47.)
  • Admittedly, by 2021 a strengthening in demand will give firms the confidence to pass on at least some of the recent rise in labour costs. But this is likely to be offset by a rise in sterling, triggered by any improvement in the economy, which would dampen core goods inflation. (See Chart 48.)
  • So by averaging 1.6% in 2020 and 1.7% in 2021, inflation is set to remain below the 2% target over the next few years.

Inflation Charts

Chart 41: CPI Inflation (%)

Chart 42: Wholesale Energy Prices & Utility Inflation

Chart 43: Wholesale & Consumer Food Prices

Chart 44: Pay & Core Services Inflation

Chart 45: Firms Costs’ & Core Services CPI (% y/y)

Chart 46: US GDP & Core Inflation

Chart 47: Inflation (%)

Chart 48: Sterling TWI & Core Goods Prices

 

Sources: Refinitiv, Capital Economics, DEFRA


Monetary & Fiscal Policy

Hawkish turn by the MPC may catch the markets off guard in 2021

  • We suspect that an additional loosening in fiscal policy in the Budget will reduce the need for the Monetary Policy Committee (MPC) to cut interest rates. In fact, the financial markets may well be caught out next year as the MPC shifts towards raising interest rates.
  • It’s pretty clear that after a decade of austerity the government is now in the mood to spend. The new fiscal rules have been designed to allow this. When compared to the previous Chancellor’s aim to balance the budget in the mid-2020s, Savid Javid’s new fiscal rule that the overall deficit can be as big as 3% of GDP mean policy can be significantly looser. (See Chart 49.)
  • Admittedly, almost 2.0 percentage points (ppts) of that extra 3% of fiscal space has already been filled by the accounting change to the treatment of student loans and the recent easing in GDP growth. And the extra government spending announced in September’s Spending Round, which will kick-in when the 2020/21 financial year starts in April, has used up another 0.5ppts. (See Chart 50.)
  • That leaves 0.5% of GDP left (just over £10bn), which we think the Chancellor will use up in the Budget on 11th March by announcing an increase in public investment. Taken together, the Spending Round and Budget may therefore loosen fiscal policy by about 1% of GDP.
  • That suggests the budget deficit will rise from 2% of GDP in 2019/20 to around 3%. So rather than fall from 80% to close to 70%, the debt to GDP ratio will drop only a bit below 80%. (See Chart 51.)
  • Such a fiscal stimulus would a bit smaller than the loosening of 1.5% of GDP that President Trump put in place in the US in 2018. But by focusing on spending and investment rather than tax cuts, the UK’s stimulus may be just as effective in boosting economic growth. (See Chart 52.) We have assumed that fiscal policy will boost GDP growth by a total of 1% spread over the 2020 and 2021 calendar years.
  • The weak performance of the economy late last year and continued uncertainty over the UK’s future relationship with the EU mean there is a decent chance that the MPC cuts interest rates from 0.75% to 0.50% in the coming months.
  • But we think that the latest signs that the economy turned a corner after the election together with the coming fiscal stimulus mean it is more likely that rates won’t be cut this year. (See Chart 53.)
  • That said, rates are unlikely to rise this year either, not least as there remains a risk of something similar to a no deal at the end of the transition period on 31st December 2020.
  • Things could change in 2021, though. If we are right in expecting there to be no major step change in the UK-EU relationship at the end of this year, fiscal policy to provide a decent boost to the economy and the global economy to improve, then the MPC may shift from warning about rate cuts to warning about rate hikes.
  • The MPC won’t raise rates rapidly. It has the benefit of learning from the Fed, who overestimated the inflationary effects of the US fiscal stimulus and arguably raised rates too far. (See Charts 54 & 55.)
  • But even if the MPC were to raise rates just once next year, from 0.75% to 1.00%, that would be a big surprise to the financial markets as they are expecting rates to stay below 0.75% for the next couple of years. (See Chart 56.)

Monetary & Fiscal Policy Charts

Chart 49: PSNB (Exc. Public Banks, As a % GDP)

Chart 50: PSNB (Exc. Public Banks, As a % GDP)

Chart 51: Net Debt (As a % of GDP)

Chart 52: Size & Effect of Fiscal Stimulus (% of GDP)

Chart 53: Surveys of Activity & Sentiment (Standardised)

Chart 54: US PCE Inflation (%)

Chart 55: US Fed Funds Rate (%)

Chart 56: Expectations for Bank Rate (%)

 

Sources: Refinitiv, IHS Markit, OBR, Fed, Bloomberg, Capital Economics


Long-term Outlook

Brexit effect cushioned by technology-induced productivity boost

  • We suspect that the dampening effect of Brexit on the economy’s long-term rate of GDP growth will eventually be cushioned by a rise in productivity growth triggered by the digital revolution. Meanwhile, we doubt that a sharp rise in government debt over the next 20 to 30 years would lead to much higher gilt yields.
  • Whatever the future relationship, Brexit will have a downward influence on the economy’s potential rate of GDP growth. Lower net migration will contribute to smaller increases in the size of the labour force and a rise in the barriers to trade will trim productivity growth.
  • However, those effects are unlikely to be huge. The fall in net migration from 340,000 a year before the EU referendum in 2016 to 212,000 in mid-2019 suggests that much of the adjustment may have already happened. Our forecasts incorporate a further easing to 190,000 a year by 2025. That would cut the annual growth of the labour force by 0.1ppt.
  • Instead, the bulk of the decline in the growth of the labour force that we expect, from just under 1.0% in 2019 to 0.4% in 2030 and to 0.2% in 2050, is driven by the ageing of the population. (See Table 2.)
  • Meanwhile, our assumption that the UK will eventually negotiate a Canada-style Free Trade Agreement with the EU may be consistent with productivity growth being only 0.2% lower per year than if the UK remained in the EU.
  • And we believe that over the next 10 to 20 years the benefits to productivity growth from the digital revolution will start to emerge. The UK’s flexible labour market and progressive attitude to adopting new technology means it is well positioned. As such, we are hopeful that productivity growth will gradually rise from the average rate of 0.5% over the past five years to 1.5% between 2030 and 2050. (See Chart 57.)
  • We are not expecting climate change to materially influence overall GDP growth in the UK. Indeed, the 40% cut in emissions since 1990 hasn’t had an obvious influence on GDP growth so far. (See Chart 58.) In any case, the UK has been progressive by international standards, with current legislation requiring carbon emissions to be net zero by 2050. And there is a growing political consensus for an even quicker timetable to reach this goal.
  • Overall, we expect that the UK’s potential GDP growth rate will stay around 1.6%-1.7% over the coming decades.
  • There is little reason to expect inflation to rise above the 2% target in the long term. If anything, the UK is more likely to succumb to inflation being stuck below 2%, as it is currently in most advanced economies.
  • We expect that a gradual rise in the policy rate towards its neutral rate of about 2.5% will contribute to 10-year gilt yields rising to about 3.75%. (See Chart 59.)
  • Higher borrowing costs would contribute to a rising budget deficit and higher government debt. But the main reason why current policies imply that government debt will rise from 80% of GDP now to almost 140% in 2050 is because the ageing of the population will require much higher spending without generating higher tax receipts. (See Chart 60.)

Long-term Outlook Charts

Chart 57: Productivity & Labour Force (%y/y)

Chart 58: CO2 Emissions

Chart 59: Policy Rate & 10-Year Gilt Yield (%)

Chart 60: Government Budget Balance & Debt

 

Sources: Refinitiv, 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

1.5

1.6

1.6

1.7

Real consumption

0.4

2.0

2.1

1.5

1.5

1.6

Productivity

0.2

0.6

0.5

1.1

1.1

1.5

Employment

0.3

1.4

1.0

0.5

0.4

0.2

Unemployment rate (%, end of period)

7.9

5.4

3.9

3.9

3.8

3.8

Wages

3.0

1.6

3.1

3.2

3.2

3.4

Inflation (%)

2.7

2.3

1.8

1.9

2.0

2.0

Policy interest rate (%, end of period)

0.50

0.50

0.75

1.75

2.50

2.50

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

3.51

1.96

1.00

2.32

3.75

3.75

Government budget balance (% of GDP)

-7.0

-4.6

-2.5

-1.2

-2.7

-6.4

Gross government debt (% of GDP)

49.1

79.3

82.4

79.1

75.8

97.7

Current account (% of GDP)

-3.3

-3.9

-4.0

-3.7

-3.9

-5.1

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

1.57

1.47

1.35

1.32

1.35

1.40

Nominal GDP ($bn)

2,508

2,825

2,804

3,551

4,332

9,370

Population (millions)

63

65

68

69

70

74

* Assumes the UK and the EU agree some kind of fudge that means there is not a big step change in their relationship on 31st December 2020.


Paul Dales, Chief UK Economist, +44 20 7808 4992, paul.dales@capitaleconomics.com
Ruth Gregory, Senior UK Economist, +44 20 7811 3913, ruth.gregory@capitaleconomics.com
Thomas Pugh, UK Economist, +44 20 7808 4693, thomas.pugh@capitaleconomics.com
Andrew Wishart, UK Economist, +44 20 7808 4062, andrew.wishart@capitaleconomics.com
James Yeatman, Research Economist, +44 20 7808 4694, james.yeatman@capitaleconomics.com