Recovery put on ice - Capital Economics
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Recovery put on ice

UK Economic Outlook
Written by Paul Dales
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The new COVID-19 restrictions will put the economic recovery on ice for the next few months and will prevent the economy from climbing back to its pre-crisis level until the end of 2022. The possibility of even tighter COVID-19 restrictions and of a no deal Brexit at the end of the year mean there’s a risk that the recovery goes into reverse. What’s more, as some of the government’s support measures expire, this next phase of the recovery will be more painful for households and businesses. That’s why we think the Bank of England will expand QE by a further £250bn by the end of 2021 and won’t raise interest rates above 0.10% until 2025.

  • Overview – The new COVID-19 restrictions will put the economic recovery on ice for the next few months and will prevent the economy from climbing back to its pre-crisis level until the end of 2022. The possibility of even tighter COVID-19 restrictions and of a no deal Brexit at the end of the year mean there’s a risk that the recovery goes into reverse. What’s more, as some of the government’s support measures expire, this next phase of the recovery will be more painful for households and businesses. That’s why we think the Bank of England will expand QE by a further £250bn by the end of 2021 and won’t raise interest rates above 0.10% until 2025.
  • Forecasts – Our forecasts assume that the current COVID-19 restrictions are tightened somewhat in the coming months and last in some form until April 2021. They also assume that a “slim” trade in goods Brexit deal is agreed by 31st December 2020 and that other arrangements (i.e. equivalence for financial services) are put in place. (See Table 1.) Alternative forecasts based on a no deal Brexit are shown in Tables 2 & 3.
  • Consumer Spending – The impressive bounce back in consumer spending will probably run out of steam due to renewed closures of some consumer-facing firms, falling employment and subdued wage growth.
  • Investment – While dwellings investment is enjoying a rapid V-shaped recovery, business investment will remain very subdued for the next couple of years.
  • External Demand – The trade surplus triggered by the COVID-19 lockdown is unlikely to be sustained. But over the next few years the trade deficit will probably be smaller than it was before the crisis.
  • Labour Market – The full fallout from the crisis probably won’t be clear until next year, when we think the unemployment rate will rise from 4.5% now to a peak of almost 8% in the second half of 2021.
  • Inflation – After rising from just above zero now to almost 2% late next year, we suspect that the big amount of spare capacity will result in inflation settling around 1.5% in 2022 rather than close to the 2.0% target.
  • Monetary & Fiscal Policy – We doubt the government will raise taxes for a few years yet. The Bank of England may shun negative interest rates for 6-12 months, but it will expand QE by more than most expect.
  • Long-term Outlook – The drag on the economy’s long-term growth rate from Brexit will probably be offset by a rise in productivity growth triggered by the accelerated use of technology in the workplace.

Key Forecasts Table

Table 1: Key Forecasts*

2019

2020

2021

Annual (% y/y)

Q4

Q1

Q2

Q3f

Q4f

Q1f

Q2f

Q3f

Q4f

Average 2010-18

2019

2020f

2021f

2022f

Demand (% q/q)

GDP

0.1

-2.5

-19.8

15.6

1.3

0.8

2.2

1.2

1.2

1.9

1.3

-10.4

6.0

4.5

Consumer Spending

-0.4

-3.0

-23.6

19.0

2.4

1.3

2.5

1.0

1.0

2.1

0.8

-12.7

7.6

5.0

Government Consumption

0.7

-3.9

-14.6

17.0

2.1

2.1

2.1

2.1

2.1

0.8

4.1

-6.3

11.0

4.4

Fixed Investment

-1.7

-1.0

-21.6

14.9

2.1

0.3

0.3

1.2

1.1

2.6

1.5

-11.5

3.5

4.9

Business Investment

-0.2

-0.5

-26.5

15.0

-1.0

0.5

1.5

1.5

1.5

9.2

1.1

-14.5

0.7

7.5

Stockbuilding1 (contribution, ppts)

1.6

-0.5

-0.7

1.0

0.2

-0.4

0.2

0.0

0.0

0.2

0.1

-0.2

0.1

0.0

Domestic Demand2

-0.2

-2.0

-23.3

19.3

2.5

0.9

2.3

1.3

1.3

2.0

1.5

-12.5

7.5

5.0

Exports

1.7

-10.7

-11.0

10.7

4.0

0.1

1.1

1.1

1.1

3.2

2.8

-9.9

7.0

3.7

Imports

0.4

-9.2

-22.7

22.3

8.0

0.3

1.4

1.3

1.4

3.6

3.3

-16.9

10.2

5.1

Net Trade2 (contribution, ppts)

-1.0

0.9

2.6

-2.9

-1.2

-0.1

-0.1

-0.1

-0.1

-0.1

-0.4

2.3

-1.5

-0.5

Labour Market (% q/q)

 

 

 

Unemployment (ILO measure, %)

3.8

4.0

4.1

4.6

5.8

6.1

6.4

7.1

7.7

6.3

3.8

4.6

6.8

6.8

Employment

0.6

0.2

-1.0

-0.5

-2.2

-0.5

-0.1

0.5

0.6

1.2

1.1

-0.9

-2.3

2.1

Total Hours Worked

-0.1

-3.8

-15.4

14.3

0.4

0.9

0.9

0.8

0.9

0.4

1.4

-9.0

5.0

2.8

Productivity (output per hour)

0.2

1.4

-5.2

1.2

0.9

-0.1

1.3

0.4

0.3

0.5

-0.1

-1.5

1.0

1.6

Income & Saving (%q/q)

 

 

 

Nominal Average Weekly Earnings3

0.5

0.0

-2.5

3.5

2.0

0.3

0.3

0.3

0.3

2.0

3.4

1.4

3.5

1.5

Real Average Weekly Earnings4

0.3

0.0

-2.5

3.1

1.9

0.4

-0.7

-0.1

-0.2

-0.3

1.6

0.5

2.1

0.0

Real Household Disposable Income

1.4

-0.6

-2.3

1.7

0.1

-0.7

-0.1

0.2

0.2

1.7

1.7

-0.5

-0.3

2.0

Saving Ratio (%)

7.7

9.6

29.1

17.6

15.6

14.0

12.0

11.1

10.4

8.5

6.8

18.0

11.9

9.3

Prices (% y/y)

 

 

 

CPI

1.4

1.7

0.6

0.6

0.6

0.5

1.4

1.5

1.8

2.3

1.8

0.9

1.3

1.6

Core CPI5

1.6

1.6

1.4

1.3

1.2

1.1

1.8

1.9

1.9

2.1

1.7

1.4

1.7

1.5

CPIH

1.4

1.7

0.8

0.8

0.7

0.6

1.4

1.5

1.8

2.1

1.7

1.0

1.3

1.6

RPI

2.2

2.6

1.2

1.0

1.2

1.4

2.4

2.4

2.7

3.1

2.6

1.5

2.2

2.3

RPIX

2.2

2.7

1.4

1.2

1.4

1.5

2.3

2.3

2.5

3.2

2.5

1.7

2.2

2.2

Nationwide House Prices (end period)

1.4

3.0

0.0

5.0

4.0

3.3

2.4

-0.1

0.0

3.6

1.4

4.0

0.0

0.7

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

Announced BoE QE (£bn)

435

645

745

745

845

845

945

945

995

351

435

845

995

995

10-Year Gilt Yield (%)

0.74

0.39

0.18

0.25

0.15

0.15

0.15

0.15

0.15

2.06

0.83

0.15

0.15

0.15

Sterling Trade-weighted Index

80.8

78.1

76.6

77.0

79.3

79.2

79.1

79.0

78.9

82.3

80.8

79.3

78.9

78.9

$/£

1.33

1.24

1.25

1.29

1.35

1.35

1.35

1.35

1.35

1.49

1.33

1.35

1.35

1.35

Euro/£

1.18

1.14

1.14

1.14

1.13

1.13

1.13

1.13

1.13

1.21

1.18

1.13

1.13

1.13

Current Account & Public Finances

 

 

 

Current Account (£bn)

-8

-23

-3

-10

-15

-16

-16

-17

-18

-74

-89

-51

-67

-75

% of GDP

-2.4

-3.7

-0.6

-1.8

-2.7

-2.8

-2.8

-2.8

-3.0

-3.9

-4.0

-2.4

-2.9

-3.0

PSNB6 (£bn, financial year)

91

57

390

200

160

% of GDP (financial year)

1.3

2.6

19.6

9.1

6.9

Global (% y/y)

 

 

 

World GDP7(CE estimate for China)

2.9

-3.2

-9.3

-4.2

-2.4

4.5

12.2

6.7

5.3

3.6

2.9

-4.8

7.2

4.0

Oil Price (Brent, $pb, end period)

66

23

41

42

45

47

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 current COVID-19 restrictions are tightened somewhat and last until April 2021. Assumes the UK and the EU agree a slim trade in goods deal by the end of the year. (See here.) For forecasts based on a no deal Brexit, see Tables 2 & 3.

No Deal Brexit Forecast Tables

Table 2: Key Forecasts – Cooperative No Deal Brexit*

2019

2020f

2021f

2022f

GDP (% y/y)

1.3

-10.4

5.0

4.0

CPI Inflation (% y/y)

1.8

1.9

2.0

2.0

Unemployment (ILO measure, %)

3.8

4.6

7.3

7.0

Real Average Earnings1 (% y/y)

1.6

-0.5

1.5

-0.5

Bank Rate (%, end period)

0.10

0.10

0.10

0.10

10-Year Gilt Yield (%, end period)

0.83

0.05

0.10

0.15

$/£ (end period)

1.33

1.15

1.25

1.30

Euro/£ (end period)

1.18

0.96

1.04

1.08

Sources: Refinitiv, Capital Economics; 1Earnings deflated by CPI

* Assumes the UK and the EU do not agree a trade deal, but side deals are in place and both sides make efforts to reduce the disruption. (See here.)

Table 3: Key Forecasts – Uncooperative No Deal Brexit*

2019

2020f

2021f

2022f

GDP (% y/y)

1.3

-10.4

3.3

4.5

CPI Inflation (% y/y)

1.8

1.9

2.2

2.3

Unemployment (ILO measure, %)

3.8

4.6

8.2

7.7

Real Average Earnings1 (% y/y)

1.6

-0.5

1.3

-0.8

Bank Rate (%, end period)

0.10

0.10

0.10

0.10

10-Year Gilt Yield (%, end period)

0.83

0.05

0.10

0.15

$/£ (end period)

1.33

1.10

1.20

1.30

Euro/£ (end period)

1.18

0.92

1.00

1.08

Sources: Refinitiv, Capital Economics; 1Earnings deflated by CPI

* Assumes the UK and the EU do not agree a trade deal and the side deals that are currently in place are removed. (See here.)


Overview

Recovery set back by a year

  • The possibility of more restrictions to contain the spread of COVID-19 and of a no deal Brexit mean the risks to our GDP forecasts lie on the downside. We think that the combination of an extra £250bn of Quantitative Easing and of interest rates being no higher than 0.10% for five years will keep gilt yields at historic lows.
  • The pace of the rebound in GDP from the 26% fall triggered by the initial COVID-19 lockdown was impressive. But in response to the new COVID-19 restrictions, we have revised down our forecasts. (See Chart 1.) We now think that GDP won’t rise at all in the last three months of the year and won’t get back to its pre-crisis peak until the end of 2022. (See Chart 2.)
  • That’s based on our assumptions that the new restrictions are tightened a bit further, that they last in some form for at least six months and that a “thin” Brexit deal is agreed before the status-quo transition period ends on 31st December 2020.
  • An easing in restrictions earlier and/or the release of a vaccine would result in the recovery being stronger and faster. But the downside risks, such as even tighter restrictions (e.g. a national “circuit-breaking” lockdown) and a no deal Brexit, currently feel bigger.
  • As many arrangements have been made, the gap between a Brexit deal and a no deal has shrunk. We estimate that a “cooperative” no deal, in which the UK and EU work together to minimise disruption, would mean GDP in 2021 is about 1.0% lower than otherwise. In an “uncooperative” no deal, in which there is no collaboration, GDP may be about 2.5% lower. (See Chart 3.) Either would set back the UK’s recovery from the COVID-19 crisis relative to other economies.
  • Whatever happens with Brexit, the government is unlikely to rush to bring down the budget deficit, which we think will be worth £390bn (20% of GDP) in 2020/21. (See Chart 4.)
  • But equally, the unwinding of some of the government’s temporary support means that households and businesses will soon feel more of the pain. Although the government’s new Job Support and local lockdown furlough schemes will cushion some of the blow from the end of the national furlough scheme, the jobless rate will probably still rise from 4.5% in August to almost 8.0% during next year. (See Chart 5.)
  • The end of the moratorium means that business bankruptcies will soon start to rise too. That’s one of a number of reasons why business investment will probably remain one of the weakest parts of the economy. (See Chart 6.)
  • The end of some other government policies, such as the Eat Out to Help Out restaurant discount scheme and the VAT cut for the hospitality and tourism sectors, will contribute to inflation rising from almost zero in August to almost 2% late in 2021. If there were a no deal Brexit, it could peak at 3.2-3.8%. (See Chart 7.)
  • But the subdued economic recovery probably means that in 2022 inflation will settle closer to 1.5% than the 2.0% target. We doubt the Bank of England will cut interest rates below zero in the next 6-12 months. But our forecast that it will expand QE by a further £250bn and keep interest rates no higher than 0.10% until 2025 explains why, unlike others, we don’t think gilt yields will rise. (See Chart 8.)
  • Overall, the economy is entering a harder and slower phase of the recovery. And the risk is that the recovery is set back further by either more COVID-19 restrictions or a no deal Brexit.

Overview Charts

Chart 1: Quarterly GDP (Q4 2019 = 100)

Chart 2: Monthly GDP (February 2019 = 100)

Chart 3: Quarterly GDP (Q4 2019 = 100)

Chart 4: Public Sector Net Borrowing (As a % of GDP)

Chart 5: ILO Unemployment Rate (%)

Chart 6: Expenditure Breakdown of GDP (Q4 19 = 100)

Chart 7: CPI Inflation (%)

Chart 8: 10-Year Gilt Yield (%)

Sources: Refinitiv, OBR, Bloomberg, Capital Economics


Consumer Spending

The hard part is just beginning

  • All the evidence suggests that consumer spending has rebounded rapidly after its 23.6% q/q drop in Q2. However, as government support is withdrawn, unemployment rises and more restrictions are put in place, consumers’ ability and willingness to spend will decline. As a result, total consumer spending is unlikely to return to its pre-crisis level until the end of 2022.
  • Consumer spending seems to have made an impressive recovery in the months since the economy was reopened. Total retail sales were 4.0% above their pre-pandemic level in August. (See Chart 9.) Admittedly, this is partly due to strong growth in online sales and partly because spending has shifted away from hospitality and leisure services and towards goods. (i.e. going out for fewer meals but buying more cushions). The mini-boom in the housing market will continue to boost demand for household goods for a while. (See Chart 10.)
  • However, the easy bit of the recovery is now over. The huge rise in involuntary saving, which pushed up the saving ratio to 29.1% in Q2 (see Chart 11), meant there was lots of pent up demand once the economy reopened. This explains some of the bounce back in consumer spending. But this has probably run its course. Indeed, visits to retail and recreation places have started to drop back. (See Chart 12.) This means that household incomes and the COVID-19 restrictions will be the main drivers of consumer spending over the next few years.
  • Despite the new Job Support Scheme, we expect employment to be about 4% lower by the middle of 2021 as the more generous furlough scheme ends on 31st October. What’s more, the slack in the labour market and weakness in GDP means that, after an initial rebound, nominal earnings growth may slow to just 1.5% in 2021. Real earnings may not do anything more than move sideways for a few years. We expect real household disposable income to fall by about 0.5% in 2020 and by 0.3% in 2021. (See Chart 13.)
  • Given that the job losses are likely to be concentrated in the lowest-paid sectors, such as restaurant and events staff, and low-income households tend to spend a higher share of their income, the effect on consumer spending will be especially negative.
  • In addition, the risk of further lockdowns will mean that consumer confidence will remain weaker than the economic data suggests it should be. (See Chart 14.) This means that consumers may not want to spend much.
  • And if there are more local lockdowns, as seems likely, then some households won’t be able to spend on the services they would like to, such as restaurants and pubs.
  • The result is that total consumer spending is likely to recover at a slightly slower rate than overall GDP and may not climb back all the way to its pre-virus level until 2023. (See Chart 15.) More local lockdowns would set back that recovery even further.
  • If there is a no deal Brexit, the resulting rise in inflation trigger by a fall in the pound would probably mean that real earnings decline. And if that no deal is an uncooperative one, the decline would probably be even larger. (See Chart 16.) That would mean that consumer spending takes even longer to get back to its pre-crisis level.

Consumer Spending Charts

Chart 9: Retail Sales (February 2020 = 100)

Chart 10: Housing Transactions & Spending on Household Goods (% y/y)

Chart 11: Saving Ratio (% of Disposable Income)

Chart 12: Visits to Places (% change compared to January)

Chart 13: RHDI & Real Household Spending (% y/y)

Chart 14: Consumer Confidence

Chart 15: Consumer Spending & GDP (Q4 2019 = 100)

Chart 16: Average Weekly Real Earnings (£)

Sources: Refinitiv, Apple, GfK, Capital Economics


Investment

Public investment leads the recovery, business investment lags behind

  • Government and dwellings investment will probably continue to be among the best performers in the economic recovery. But business investment is likely to be one of the worst.
  • The rapid recovery in dwellings and government investment is likely to mean that these two components of GDP are amongst the quickest to regain their pre-pandemic peaks. Indeed, the release of pent-up demand, the Help to Buy scheme and the stamp duty holiday have spurred housing demand. (See Charts 17 & 18.) And the Chancellor announced an extra £7bn (0.3% of GDP) of spending on the health capital budget and on infrastructure on 30th June.
  • However, at some point the recovery in both will peter out and could go into reverse. Pent-up housing demand will be expended in the coming months and the stamp duty cut is set to expire on 31st March 2021. What’s more, much of the announced rise in infrastructure spending has been brought forward from future years. As a result, we expect government investment to contract by 1.5% in 2021 and dwellings investment to fall in Q2 2021 before growing by a more muted 2.5% in 2022.
  • More worryingly, there are three reasons why business investment will remain subdued for longer than other parts of the economy. First, extremely high uncertainty around Brexit and the evolution of the pandemic is likely to mean that firms don’t want to invest. (See Chart 19.) The Bank of England and CBI surveys of investment intentions are still consistent with deeply depressed business investment. (See Chart 20.) Even if a Brexit deal is reached by 31st December, business investment may be soft in both Q4 2020 and Q1 2021 as businesses wait to see how a deal would work in practice.
  • Second, the lingering hit to firms’ profits and the legacy of higher corporate indebtedness may mean that firms are more risk averse. (See Chart 21.) This will prompt them to prioritise paying off debt over investment. Smaller firms may also be concerned about access to credit after the Coronavirus Business Interruption and Bounce Back loan schemes end on 30th November. And they are going to have to start repaying interest and making repayments on these loans from March 2021.
  • Third, many firms will not need to invest. Businesses were still operating at well below normal capacity rates in Q3 (see Chart 22) and we think that a large amount of spare capacity in the economy will persist for several years. In this environment, firms will be able to meet a rise in output by bringing idle capacity back online rather than investing in new capacity.
  • Admittedly, within business investment, ICT investment should be one of the bright spots. But the downturn in commercial property, in particular in the office and retail sectors, will be a drag on buildings and structures investment for many years to come.
  • Finally, businesses may stockpile goods in Q4 to prepare for the possibility of a no deal Brexit. But lower cash reserves and worries about weak demand will probably mean that the boost to GDP growth is smaller than the 1.3ppts lift seen before the original Brexit deadline on 29th March 2019. (See Chart 23.) And since this is a timing effect, stocks won’t permanently boost GDP.
  • Overall, we expect total investment to be about 1% below its pre-virus peak by the end of 2022. But business investment may still be about 5% below its peak. (See Chart 24.)

Investment Charts

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

Chart 18: Housing Transactions & Dwellings Investment (% q/q)

Chart 19: Businesses Saying Issue is in Top 3 Sources of Uncertainty (%, BoE Decision Maker Panel)

Chart 20: Investment Intentions & Business Investment

Chart 21: Private Non-Financial Business Debt & Interest Expenses

Chart 22: Firms Working Below Capacity & Business Investment

Chart 23: Manufacturing PMI & Inventories

Chart 24: Investment & GDP (Q4 2019 = 100)

Sources: Refinitiv, BoE, IHS Markit, Capital Economics


External Demand

Large trade deficit may not return as UK recovery lags behind

  • The unusual trade surplus recorded when trade collapsed during lockdown will soon be eliminated. But continued low international travel and the UK’s relatively slow economic recovery may mean that the trade deficit won’t be as large as it was. Meanwhile, a no deal Brexit could disrupt trade flows again.
  • The unwinding of the 11% and 23% respective fall in exports and imports in Q2 due to the COVID-19 lockdown will mean that the UK’s recent trade surplus will evaporate. (See Chart 25.) As a result, after providing a large boost to GDP in Q1 and Q2, net trade will have been a sizeable drag on GDP in Q3. But that will only have restrained the overall recovery a bit.
  • However, there are two reasons why we doubt that the trade balance will return to the pre-virus situation of a large trade deficit, of 1.5% of GDP. First, while the recovery in Europe appears to be slowing, it has been much faster in the US and China. As a result, we expect GDP of the UK’s trade partners to rebound swiftly, which should lead to a strong rebound in UK exports. (See Chart 26.)
  • Second, the recovery in imports may be more muted given the slower recovery we expect in the UK. (See Chart 27.) Our forecast is that UK GDP won’t get back to its pre-virus level at the end of 2022. And weak business investment, which has a high import intensity, will further reduce demand for imports.
  • Admittedly, the apparent shift in consumer spending towards goods, which tend to be imported, and away from services, which are produced domestically, could boost imports.
  • But that is likely to be offset by the collapse in international travel and tourism. Previously, UK residents spent about £17bn a year more abroad than foreign residents did in the UK. The difference fell to zero in Q2 and is likely to remain low for a while yet. (See Chart 28.) That may reduce the annual trade deficit by about £8bn (0.5% of GDP) which, for context, was £25bn in total (1.5% of GDP) in 2019.
  • So, after contributing around 2ppts to GDP this year, net trade may subtract 1.5ppts in 2021 as the trade surplus turns into a small deficit. (See Chart 29.) But because the trade deficit will probably remain smaller than before, the current account balance may narrow to around 3% of GDP in 2021 from 4% in 2019. (See Chart 30.)
  • Even if the UK and EU agree a trade deal, there is likely to be some disruption to trade around the turn of the year as new customs formalities begin. But because of the pressures of the virus and companies’ reduced cashflow, we doubt there will be as much stockpiling as before past Brexit deadlines. (See Chart 31.)
  • If there is a no deal, the disruption to trade will depend on what type of no deal it is. The UK and EU could cooperate to reduce delays at the borders. But in an uncooperative no deal, the EU could slow down trade flows by imposing onerous documentation and physical checks.
  • Given that the UK runs a trade in goods deficit with the EU, any reduction in exports due to disruption would probably be offset by a bigger fall in imports. The impact on net trade and GDP may therefore be positive! But this disruption to trade would still reduce GDP via the impact on supply chains. Manufacturing is particularly reliant on inputs imported from the EU. (See Chart 32.) A no deal Brexit may reduce production if businesses can’t source the components they need.

External Demand Charts

Chart 25: Import & Export Volumes (Exc. Valuables, £bn)

Chart 26: Weighted Trade Partner GDP & UK Exports (Q4 2019 = 100)

Chart 27: UK Domestic Demand & Imports

(Q4 2019 = 100)

Chart 28: Tourism Spending & Trade Balance (£bn)

Chart 29: Net Trade Contribution to y/y GDP (ppts)

Chart 30: Current Account Balance (As a % of GDP)

Chart 31: Export & Import Volumes (£bn, Inc. Valuables)

Chart 32: Imports of Intermediate Goods & Services from the EU, 2014

Sources: Refinitiv, Capital Economics, World Input-Output Tables


Labour Market

Worse yet to come

  • The economy is on the mend, but the full fallout in the labour market from the pandemic will only appear over the next year as the government’s fiscal support unwinds.
  • Most of the 5.5 million employees who had left the national job furlough scheme by August went back to their jobs rather than into unemployment or inactivity. Indeed, employment fell by only 482,000 (1.5%) between February and August, inactivity increased by 465,000 and unemployment rose by 158,000. That left the level of unemployment at 1.5m and it raised the rate from 4.0% in February to 4.5%.
  • Admittedly, it is possible that the figures may be understating employee job losses. According to the HMRC, the number of paid employees has fallen by a larger 685,000 between February and August. (See Chart 33.) And, partly due to an increase in coverage and generosity, the number of people claiming jobless benefits has risen by 1.5m since February. (See Chart 34.)
  • Either way, the bigger picture is that there is worse to come. There is a risk that many of the 2 million or so people who in mid-September were still on partial or full furlough lose their job when the national scheme is wound down at the end of October. (See Chart 35.) That’s particularly the case in the light of the tightening restrictions to stem the resurgence in new COVID-19 cases that will hamper the economic recovery.
  • The government’s existing schemes, such as the Job Retention Bonus, the Job Support Scheme and the extension of the latter to pay 66% of the salaries of businesses forced to close by local lockdowns, should all cushion some of the blow from the end of the national furlough scheme.
  • But while the cliff edge has been delayed and lowered, it has not been removed. We think the unwinding of government support will cause the 1.5% fall in employment so far to turn into a 4.0% fall by early in 2021. (See Chart 36.)
  • A fall in the labour force will probably continue to cap the rise in unemployment. Indeed, as vacancies were still 40% below pre-crisis levels by the end of August, there’s not much incentive for those who have lost their jobs to look for a new one immediately. (See Chart 37.)
  • But as the economy recovers, more people will resume looking for work, causing unemployment to rise. We expect an increase in unemployment from 1.5m to 2.6m to raise the jobless rate from 4.5% in August to almost 8.0% during 2021. (See Chart 38.) Further ahead, the lasting damage to activity in sectors such as tourism and leisure suggests that the unemployment rate will still be around 6% by the end of 2022. That would be well above its pre-pandemic level of 3.8%.
  • Meanwhile, the rebound in average earnings because workers exiting the furlough scheme are going from receiving 80% of their salaries on the furlough to receiving 100%, will continue in the coming months. By August, both total earnings and earnings excluding bonuses had more than reversed all of their previous falls. (See Chart 39.)
  • But a rising unemployment rate and greater slack in the labour market will mean that in 2022 earnings may grow by less than 2%. (See Chart 40.) As a result, the labour market will remain a disinflationary force for some time to come.

Labour Market Charts

Chart 33: Employment (Millions)

Chart 34: Claimant Count & ILO Unemployment (000s)

Chart 35: No. of People on Furlough Scheme (Millions)

Chart 36: Employment & GDP

Chart 37: Recruitment Difficulties & Vacancies (Standardised)

Chart 38: Employment & Unemployment Rates (%)

Chart 39: Average Weekly Nominal Earnings (£, SA)

Chart 40: Unemployment Rate & Average Earnings

Sources: Refinitiv, HMRC, ONS, BoE, Capital Economics


Inflation

Undershooting the target

  • The inevitable rebound in inflation will probably run out of steam in 2022 to leave it at 1.5% rather than at the 2.0% target. And while the risk of a more meaningful rise in inflation is greater further ahead, we doubt that the Bank of England will let down its guard.
  • A rise in CPI inflation from the low point of 0.2% reached in August to close to the 2.0% target in late 2021 is already pretty much baked in the cake. That’s because the declines in consumer prices triggered by the government’s Eat Out to Help Out restaurant scheme, the plunge in oil prices earlier this year and the temporary VAT cut for the tourism/hospitality sectors will fall out of the annual comparison in September, March and April respectively.
  • And there are three reasons why we think inflation will then drop back to 1.5% rather than rise someway above 2.0%. (See Chart 41.)
  • First, we suspect goods inflation will remain fairly low. Admittedly, it may rise a bit if the current increase in the orders to inventories ratio is sustained, which reflects the rebound in the demand for goods being stronger than the rebound in production. (See Chart 42.) But it probably won’t be long before production catches up. And in any case, if there’s a Brexit deal, goods inflation will be capped by a strengthening in the pound. (See Chart 43.)
  • Things would be different if there were a no deal Brexit. In that case, we estimate that the boost to import price inflation from a fall in the pound and from higher import tariffs would push up CPI inflation to a peak of between 3.2% and 3.8%. But even then, inflation would fall back again before too long. (See Chart 44.)
  • Second, there aren’t many signs that businesses in the services sector are passing on to their customers the extra costs associated with social distancing restrictions. A recent Bank of England survey provided no indication of such a rise. (See Chart 45.)
  • Third, large amounts of spare capacity are forcing businesses to focus on maintaining their customer base and allowing them to cap other costs. Wages are the biggest cost for most services firms. Our forecast that in 2022 earnings growth will be below 2% points to only a partial rebound in services inflation. (See Chart 46.)
  • Of course, once this spare capacity is used up, there is a risk that inflation will rise above 2.0%. That’s especially the case when, unlike after the Global Financial Crisis when it got stuck in the financial system, the huge monetary and fiscal stimulus has worked its way into the hands of households and businesses who are more likely to spend it. (See Chart 47.)
  • What’s more, policymakers may become inclined to let inflation rise. After all, by lowering real interest rates, it would give the economy an extra kick. And as long as the markets didn’t anticipate it, higher inflation would erode the government’s debt burden.
  • But we suspect that the Bank of England and the Chancellor are more wedded to the 2% inflation target than the Fed, whose recent shift to an average inflation target implies it wants inflation to spend some time above 2%. So if inflation does start rising above 2%, then they will remove some of the stimulus. Since UK break-even inflation expectations have not risen above pre-pandemic levels, the markets seem to agree with us. (See Chart 48.)

Inflation Charts

Chart 41: CPI Inflation (%)

Chart 42: Producer Prices & Orders/Inventories Ratio

Chart 43: Core Goods CPI & Sterling TWI

Chart 44: CPI Inflation (%)

Chart 45: BoE Agents’ Scores & CPI Services Prices

Chart 46: Average Earnings & Core Services Inflation

Chart 47: M4 Money Holdings (£bn)

Chart 48: Market Inflation Expectations (%)

Sources: Refinitiv, Bank of England, IHS Markit, Capital Economics


Monetary & Fiscal Policy

Fiscal support fading, but won’t go into reverse

  • Concern for the economy should, and probably will, overwhelm the Chancellor’s ambition to balance the books. And with the Bank of England set to embark on more QE and keep interest rates near 0% (but probably not negative) for many years, low government borrowing costs mean there is no to significantly cut spending or raise taxes.
  • Fading fiscal support is one reason why we think that the economy will stagnate in the final few months of the year. Even after the Chancellor extended the VAT cut for hospitality/tourism, created the Job Support Scheme (JSS) and launched the local furlough, the big picture is that the government is tapering its help. (See Chart 49.) Indeed, under the Job Support Scheme the government will pay a much smaller share of employees’ wages than under the furlough scheme. (See Chart 50.)
  • But we think that the stuttering recovery and a renewed tightening in COVID-19 restrictions will put a stop to mutterings about tax increases and force the government to provide continued fiscal support. So far this year borrowing has undershot the OBR’s projection thanks to the economy doing slightly better than the fiscal watchdog expected. (See Chart 51.)
  • But new fiscal measures and the slowing recovery mean that government borrowing will probably reach £390bn this year (20% of GDP), close to the OBR’s forecast. That would be the highest budget deficit since WWII. (See Chart 52.) The deficit is likely to come down quite quickly as the hit to activity and tax revenues should be shorter than in the financial crisis, and many of the most expensive support schemes have already ended. Our forecast is that the deficit will fall to 9% in 2021/22 and to 7% in 2022/23.
  • With GDP rebounding, that should stabilise the debt to GDP ratio at just over 100%, lower than in Italy and France. (See Chart 53.) In the long run, we suspect a deficit of about 4% of GDP would keep the debt ratio steady. That means the Chancellor won’t need to “balance the books” entirely or repeat the decade of austerity that followed the financial crisis.
  • Meanwhile, although the MPC has already cut interest rates to 0.10% and raised the stock of announced QE from £475bn to £775bn this year, our forecast of sustained high unemployment suggests it will have to do more.
  • But we doubt the MPC will use negative interest rates within the next 6-12 months. Despite the Bank putting the necessary systems in place and a couple of external MPC members advocating the policy, as a whole the Committee seems more concerned that the adverse impact of negative rates on banks profitability could mean they restrict lending, making them counter-productive. Investors have recently unwound some of their bets on negative rates as a result. (See Chart 54.)
  • Instead, we expect the Bank to use more QE as its primary tool. We expect the MPC to announce a further £250bn of QE over the next year, much more than the consensus expects. (See Chart 55.) Meanwhile, Bank Rate is unlikely to rise above 0.10% for five years.
  • With inflation set to remain muted, low interest rates and further QE will ensure gilt yields stay very low rather than rise as most other forecasters expect. In fact, due to more QE by the Bank the amount of gilts held by the private sector may even fall. (See Chart 56.) With borrowing costs set to stay low for many years, the government can focus on supporting the economy rather than reducing the deficit.

Monetary & Fiscal Policy Charts

Chart 49: Timing of Covid-Related Fiscal Support Measures in 20/21 (% Ave. Monthly GDP in 2019)

Chart 50: Contribution to Employee Wages (%)

Chart 51: Cumulative Public Sector Net Borrowing (£bn)

Chart 52: Public Sector Net Borrowing (Excluding Banks, As a % of GDP)

Chart 53: Public Debt (% GDP)

Chart 54: Expectations for Bank Rate (%)

Chart 55: Forecasts for the Stock of QE Purchases (£bn)

Chart 56: Gilt Issuance & BoE Gilt Holdings (£bn since QE Started in March 2009, Nominal Values)

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


Long-term Outlook

Lasting impact on public debt, not economic growth

  • As the COVID-19 crisis is more likely to accelerate existing trends that were already underway rather than generate new ones, it may have surprisingly little impact on economic growth in the long term. But one legacy will be higher public debt burdens and lower interest rates for longer.
  • If social distancing measures were required forever, then the COVID-19 crisis would significantly change the size and shape of the economy in the long run. Requirements for businesses to have fewer employees and customers on the premises would reduce productivity growth.
  • An aversion to overseas travel would probably result in less net migration too and reduce the growth rate of the UK’s labour force. As a result, the economy’s supply capacity would be lower than otherwise and GDP would grow at a slower pace in the long term.
  • But we think it is more likely that social distancing will be required temporarily, perhaps for a year or two, until a vaccine is developed or herd immunity is achieved. If so, then the trends that are most likely to last are the ones that were already underway and have been accelerated by the crisis.
  • They include spending online, a reduction in the use of cash, the adoption of technology in the workplace and a shift towards working from home. The latter could have some major knock-on effects, such as a reduction in the demand for commercial property and a rise in the demand for residential property in smaller cities and rural areas.
  • It just so happens that the trends that are most likely to be temporary are the ones that reduce productivity and the trends that are more likely to stick are those that are more likely to boost productivity.
  • For some time, we have been expecting the digital revolution to have an upward impact on productivity growth. It’s possible that the COVID-19 crisis means that happens sooner than we previously thought.
  • Of course, in whatever shape it comes, Brexit will probably have a downward influence on productivity growth. And by further reducing net migration, it may exacerbate the easing in the growth of the labour force that is already baked in the cake by the gradual ageing of the population.
  • But we suspect that the boost to productivity growth from a greater use of technology will more than offset slower growth in the labour force to leave GDP growing by around 1.7% in the long term. (See Chart 57.)
  • The huge fiscal support put in place to counter the COVID-19 crisis means that if left unchecked, public debt could easily jump from 100% of GDP to above 200% of GDP. (See Chart 58.) That would take it close to the peak of 250% seen during the Second World War. (See Chart 59.)
  • But as long as the Bank of England keeps interest rates low, there is unlikely to be a leap in gilt yields and a debt crisis. With the COVID-19 crisis unlikely to unleash inflation, we think the Bank will be only too happy to oblige. In fact, high public debt means that policymakers are more likely to work together to keep government borrowing costs low.
  • As such, we doubt that interest rates or gilt yields will rise significantly for many years. (See Chart 60.)

Long-term Outlook Charts

Chart 57: Real GDP (%y/y)

Chart 58: Government Budget Balance & Debt

Chart 59: Government Debt (As a % of GDP)

Chart 60: Bank Rate & 10-Year Gilt Yield (%)

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

-0.9

3.3

1.6

1.7

Real consumption

0.4

2.0

-1.2

3.5

1.6

1.7

Productivity

0.3

0.6

-1.7

2.9

1.1

1.4

Employment

0.3

1.4

0.8

0.4

0.4

0.3

Unemployment rate (%, end of period)

7.9

5.4

4.6

5.5

5.5

4.0

Wages

3.0

1.6

1.4

2.8

3.2

3.3

Inflation (%)

2.7

2.3

1.7

1.8

2.0

2.0

Policy interest rate (%, end of period)

0.50

0.50

0.10

0.10

1.00

2.00

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

3.51

1.96

0.15

0.61

1.50

3.00

Government budget balance (% of GDP)

-7.0

-4.6

-4.6

-5.3

-4.9

-10.3

Gross government debt (% of GDP)

49.0

79.2

85.6

90.8

101.5

147.6

Current account (% of GDP)

-3.3

-4.0

-4.0

-3.3

-3.4

-4.6

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

1.57

1.47

1.35

1.40

1.41

1.43

Nominal GDP ($bn)

2,514

2,829

2,765

3,995

4,793

10,101

Population (millions)

63

65

68

69

70

74

Assumes the UK and the EU agree a slim trade in goods deal by the end of the year. (See here.)


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
Bradley Saunders, Research Economist, +44 7712 516 902, bradley.saunders@capitaleconomics.com