Coronavirus concerns to prompt rate cut

  • In a change to our previous forecast, we now think that the economic effects of the coronavirus will result in GDP growth slowing to just 0.7% this year and will soon prompt the Bank of England to cut interest rates from 0.75% to 0.50%. That said, we believe that a sizeable fiscal stimulus will contribute to both GDP growth and interest rates being higher next year than the financial markets currently expect.
  • We’ve been warning since the middle of February that the economic effects of the coronavirus on the global economy would lead to weaker GDP growth in the UK. (See here.) And last week we flagged up the possibility that the sharp falls in equity prices may force the Bank of England to cut interest rates. (See here.)
  • Since then we have become more convinced that the coronavirus will eventually hamper domestic activity as well as demand from overseas. We are not epidemiologists, but judging by the progression of the virus in other countries it seems sensible to assume that over the coming weeks the number of coronavirus cases in the UK will rise from 51 now to somewhere in the hundreds or thousands.
  • It is extremely uncertain what that would mean for the economy as it depends on how the government, households and policymakers respond. After all, the lesson from the experience of China is that it is not the virus itself that causes most of the reduction in economic activity, but the measures put in place by the government to contain it and to delay the spread. (See here.)
  • The UK government won’t be as draconian as China’s. But its “Coronavirus: action plan” does float the possibility of “school closures, encouraging greater home workings [and] reducing the number of large scale gatherings”. Our forecasts assume that there will be some sporadic school closures and that some companies and households will favour working from home. On top of that, we suspect that as they avoid public places some households will spend less than otherwise on travel and in bars and restaurants.
  • We estimate that these global and domestic influences will reduce GDP growth this year by 0.3 percentage points, with most of the effect being felt in the second quarter when GDP may not rise at all. As such, we have revised down our 2020 GDP growth forecast from 1.0% at the start of the year to 0.7%.
  • At its last meeting in January, the Monetary Policy Committee (MPC) said that it may need to cut interest rates “should the more positive signals…of global and domestic activity not be sustained”. We believe that condition has now been met. And the comments of Governor Mark Carney this morning that the Bank’s response to the coronavirus will be “powerful and timely”, suggests the Bank does too.
  • As such, we now expect the Bank to cut interest rates from 0.75% to 0.50% at its next meeting on 26th March, but it could easily follow the Fed’s emergency 0.50% cut earlier today by taking action sooner. It may also provide extra support by encouraging banks to lend more freely by reducing the counter-cyclical capital buffer and/or by extending the Term Funding Scheme. At the same time, we expect that in the Budget on 11th March the Chancellor will announce a package of “coronavirus” measures worth up to £5bn (0.2% of GDP), which could include more spending on the NHS and temporary tax breaks for companies.
  • Despite coronavirus, our GDP growth and interest rate forecasts for 2021 are still higher than the forecasts of most. We believe that a rise in public investment in next Wednesday’s Budget will build on the rise in government spending already due to begin in April. That should be enough to prevent the MPC from cutting interest rates to the level of 0.25% expected by the markets. In fact, if it contributes to GDP growth accelerating to 2.0% in 2021, as we think is likely, then the MPC may raise interest rates back to 0.75% next year. That would leave rates 0.50% higher at the end of 2021 than the markets currently expect.
  • So while we have revised down our end-year forecasts for the 10-year gilt yield to 0.75% this year (from 1.00%) and to 1.00% next year (from 1.25%), we still believe there is scope for yields to rise from their current level of 0.40%. And should the UK and the EU reach a compromise on their future trading relationship by the end of this year, we still think the pound could rise from $1.28 now to $1.35 this year.
  • Of course, there is a lot of uncertainty. If the response of the government and/or households to the coronavirus is more severe, then GDP could fall in Q2 and a short recession could be confirmed in Q3.

Paul Dales, Chief UK Economist, +44 20 7808 4992, paul.dales@capitaleconomics.com

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