COVID-19 legacy may be higher inflation and bigger public deficits - Capital Economics
UK Economics

COVID-19 legacy may be higher inflation and bigger public deficits

UK Economics Focus
Written by Ruth Gregory

Our view that the recovery from the COVID-19 pandemic will be quicker and more complete than most forecasters expect suggests that the economic legacy of the crisis may not be a permanently smaller economy but instead higher inflation and bigger public deficits.

  • Our view that the recovery from the COVID-19 pandemic will be quicker and more complete than most forecasters expect suggests that the economic legacy of the crisis may not be a permanently smaller economy but instead higher inflation and bigger public deficits.
  • We think that the economy will recover more quickly than most expect from Q2 of this year, as vaccines allow a boom in consumer spending. So rather than taking more than two years for the economy to return to its pre-virus size as most expect, we think it will do so in Q1 2022. Against this backdrop, we do not expect the Bank of England to use negative interest rates or announce more QE this year or next.
  • And we do not think it is inevitable that the economy will be smaller forever more. There are three main ways in which the crisis could cause long-term economic damage and shunt GDP onto a lower path forever. First, the destruction of the capital stock. Second, a reduction in labour supply. Third, a decline in the efficiency with which the economy utilises both capital and labour.
  • Admittedly, as far as the capital stock goes, some of the sectors hit hardest by the crisis, such as air travel, use very specific assets which cannot be easily re-deployed. So some of the capital stock could be rendered obsolete. But on top of that, the burden of repaying emergency loans may weigh on business investment for some time. Set against this is the possibility that the virus ushers in a new wave of investment in technology.
  • Meanwhile, it will be difficult for labour to shift smoothly from diminishing sectors to growing ones. For example, a waiter can’t quickly become a doctor. But the shift required after this recession will probably be much smaller than after the recessions in the 1980s and 1990s, when the manufacturing sector was decimated. Perhaps a bigger risk, then, is that the skills of young people will be permanently scarred by the disruption to both education and on-the-job training.
  • The impact on the efficiency with which the economy utilises capital and labour could go either way. If social distancing becomes semi-permanent (e.g. fewer seats in restaurants), then some firms will endure a lasting reduction in their productivity. But the crisis may have positive lasting effects on efficiency if firms retain innovative working practices developed during the crisis, such as online ordering.
  • Taking all these factors together, we do not buy into the view that it is inescapable that the downturn will leave large scars on the level and growth rate of GDP. If we are right, then there are two key implications. First, the conventional wisdom that a dose of fiscal tightening is required to repair the damage caused to the public finances by the crisis may be wrong. The clear danger is that a major fiscal tightening could undermine the recovery, actually creating longer-term economic scarring and thus magnify the future challenges for the public finances. So despite the grim warnings from the Chancellor, a tightening in fiscal policy is the last thing the economy needs right now.
  • Second, the huge amount of policy stimulus could push up inflation further ahead. That may eventually force the government to choose between either low inflation or looser fiscal policy. It can’t have both as higher interest rates will be needed to ensure the former, but lower interest rates are required to permit the latter. And it is easy to see why the government might judge that higher inflation is a price worth paying to keep running deficits, prompting an institutional slide towards accepting higher inflation. The consequence could be in the late 2020s and 2030s inflation being persistently above 2% and a budget deficit of 4-5% of GDP becoming the norm.

COVID-19 legacy may be higher inflation and bigger public deficits

This Focus is an adapted version of a presentation given to the Society of Professional Economists on 26th January 2021.

The prevailing view amongst forecasters is that the UK economy is now staring down the barrel of yet another quarterly fall in GDP in Q1 and that there will only be a significant reversal of the UK’s economic fortunes as and when the COVID-19 restrictions are eased. The more interesting economic question isn’t how or when these restrictions are lifted, but the speed and fullness of the economic recovery once the restrictions are relaxed.

What marks our forecasts out as different from the consensus is that we think that the economic recovery will be quicker and more complete than most anticipate. This Focus sets out the reasons behind our relative optimism and the implications for monetary policy, fiscal policy and inflation.

A swift recovery is around the corner

Our forecasts that annual GDP will grow by about 5.5% this year and 6.5% in 2022 imply a quicker recovery from the crisis than that forecast by the consensus and the Office for Budget Responsibility (OBR). (See Chart 1.) And rather than taking more than two years for the economy to return to its pre-pandemic size, we think it may do so in Q1 2022. (See here.)

Chart 1: Real GDP (Q4 2019 = 100)

Sources: Refinitiv, Bloomberg, OBR, Capital Economics

The main reason why we are more optimistic than most is because we think households will be more willing to spend. Admittedly, if the rise in involuntary savings turns in to a semi-permanent increase in precautionary savings, perhaps driven by fear of future virus outbreaks and the economic disruption they would create, then demand will be much slower to recover. But it is encouraging that there was no permanent rise in the saving rate after other pandemics like SARS in Asia and North America in 2002/03. (See here.)

Our view is that households will be eager to return to pubs and restaurants and to go on holiday, and that households will fund it by going back to spending the same share of their income as before the crisis. That would mean the saving rate falls from the peak of 27.4% in Q2 2020 (when the first lockdown limited how much of their income households could spend) to its long-run average of 8% by the end of 2022.

Admittedly, the amount of cash households are holding in their bank accounts has risen by more than £140bn since February last year. (See Chart 2.) If households spent all that £140bn, it could boost GDP by about 6.8%.

Chart 2: Households’ Cash Holdings (M4 ex. £bn, m/m)

Source: Refinitiv

But we do not think that households will spend some of these stocks of savings. After all, it is the richer, less income-constrained households that have saved more, and their marginal propensity to consume out of one-time income shocks is probably much lower than for low-wealth households. Households might pay down debt or put the money into other financial assets or housing. Even if households do spend some of the money, this spending might just boost imports.

Overall, we think that households will lead the economic recovery as vaccines allow a boom in spending in pubs, restaurants, hotels and on holidays. (See Chart 3.) The possibility that households spend some of their savings is an upside risk to our GDP forecasts.

Chart 3: GDP & Consumer Spending (Q4 2019 = 100)

Sources: Refinitiv, Capital Economics

If we are right in our more optimistic take that the economy will return to its pre-pandemic size in Q1 2022, then we suspect the Bank of England won’t need to expand QE or use negative interest rates this year or next. As Chart 4 shows, the Bank has yet to make much headway into the £150bn of extra QE it announced in November.

Chart 4: Bank of England Quantitative Easing (£bn)

Sources: Bank of England, Capital Economics

Will the crisis lead to permanent damage?

So we think the recovery will be quicker than most anticipate. We also think it will be more complete.

The external commentary tends to portray it as inescapable that a downturn this big will leave large permanent scars on the level and growth rate of GDP. But while we think the effects of the crisis will reverberate for many quarters and years to come, we are optimistic that given time and sufficient policy support, the economy can pretty much get back to where it would have been had the virus not come along, perhaps by the middle of the decade.

Of course, countries have not always managed to recover fully following many crises. Rather than following the pre-crisis trend after the Global Financial Crisis (GFC), real GDP instead became lodged below its previous path on a permanent basis. (See Chart 5.) That’s long-term scarring in action.

Chart 5: Real GDP (£bn)

Sources: Refinitiv, Capital Economics

But unlike the 2008 financial crisis, the 2020 COVID-19 crisis may not result in a lower path of GDP ten years from now. Prior to the GFC, the trend was inflated by housing and credit bubbles and was never likely to be matched following the crisis whatever happened. And the GFC reduced the size of the financial sector, a high productivity sector.

The COVID crisis is rather different. Potential growth had already fallen sharply before the crisis, lowering the bar in terms of the path back to “normality”. Rafts of research show that downturns involving banking crises tend to have a bigger permanent effect on output, as tighter credit conditions prevent firms from financing profitable investment opportunities. (See here.) Yet so far, a significant tightening of credit conditions has been avoided. And those sectors that may shrink are likely to be the lower productivity ones such as hospitality and leisure. So this all suggests that we should not be too pessimistic.

There are three factors that govern the supply potential of an economy, namely the amount of capital it has, the amount of workers it has, and the efficiency with which it utilises both capital and labour. We look at each in turn.

As far as the capital stock goes, some of the sectors hit hardest by the crisis use very specific assets, which cannot be easily re-deployed (e.g., aircraft). This suggests that some capital stock could be rendered obsolete. And the burden of repaying emergency loans may weigh on investment for some time, thereby limiting future increases in the UK’s capital stock.

But set against this is the possibility that the virus ushers in a new wave of investment in technology. To the extent that this is just to safeguard against another pandemic in the future, then it might not make the economy more productive or people better off. One example is spare intensive care capacity in hospitals that would not be used most of the time. But extra investment on robotics and touchless technology to solve social distancing issues or apply innovations during the crisis would be positive for long-run growth. (See Table 1.)

Table 1: Economy’s Supply Potential – Capital

Reasons to be Optimistic

Reasons to be Pessimistic

  1. Amount of Capital
  • Scrapping only in relatively small sectors (e.g. air travel).
  • Very specialised assets cannot be re-deployed.
  • Success of gov’t loan schemes preventing viable firms going under.
  • Sharp fall in investment.
  • Investment in robotics & touchless technologies.
  • Burden of repaying loans to weigh on investment.

Source: Capital Economics

As for the labour market, during recessions when the make-up of the economy is changing, it takes some time for the labour market to adjust. Sectors that are shrinking shed jobs, while sectors that are growing add jobs. But as this process isn’t seamless, the result is temporary unemployment. If the changes in the make-up of the economy are particularly big and/or the skills required to work in the sectors shedding jobs are very different to those required to work in the sectors adding jobs, then the rise in unemployment lasts for longer. In some cases, it becomes permanent and the economy’s natural rate of unemployment increases. For example, many people who lost their jobs when the manufacturing sector shrank in the 1980s and early 1990s effectively dropped out of the labour force and the supply of labour declined.

The pandemic has clearly triggered some large shifts in the make-up of the economy with jobs being cut in sectors like hospitality and leisure and jobs being created in sectors like health and IT. And it’s not easy for labour to shift smoothly between sectors. For example, a waiter can’t quickly become a doctor.

Our view is that lots of the shifts in activity over the past year will prove to be temporary. Once vaccines are widespread and COVID-19 restrictions are eased, we believe people will go back to the pubs, restaurants and theatres. (See here.) That should limit any permanent reduction in labour supply due to the changing shape of the economy.

But even if the sectoral changes in the past year were permanent, the Bank of England has estimated that the degree to which workers would need to move between jobs that involve different tasks, which the Bank calls “task reallocation”, would be smaller than required by the compositional changes in the economy in the early 1980s and early 1990s. Indeed, the Bank estimates that the required task reallocation this time would be half that of the 1975 to 2019 average. (See Chart 6.)

Chart 6: Extent to which Workers Need to Retrain (BoE measure)

Source: Bank of England

Perhaps a bigger risk, then, is that the skills of young people will be permanently scarred by the disruption to both education and on-the-job training. And that there could be a rise in longer-term unemployment. What’s more, there is a risk of a permanent reduction in the labour supply if those who have left the UK since the pandemic began stay overseas and are not replaced by new migrants (either by choice or due to restrictions on freedom of movement after Brexit). (See here.) (See Table 2.)

Table 2: Economy’s Supply Potential – Labour

Reasons to be Optimistic

Reasons to be Pessimistic

2. Amount of Labour
  • Rise in unemployment short-lived.
  • Skills of young people scarred.
  • Reallocation of tasks smaller than in 1980s/90s.
  • Higher long-term unemployment.
  • Remote working may increase labour market participation.
  • Reduced inward migration.

Source: Capital Economics

As for the impact on the efficiency with which the economy operates, it could go either way. If social distancing becomes semi-permanent, then some firms will endure a lasting reduction in their productivity. For example, a restaurant will be able to serve fewer seated customers. But the crisis may have positive lasting effects on efficiency, as firms hang on to innovative working practices, such as new websites and online services. (See Table 3.)

The key factor is that the crisis has not involved a banking crisis which tends to reduce the flow of credit to otherwise productive businesses and impairs the allocation of resources. And our sense is that the productivity sapping changes triggered by the crisis will probably prove temporary (such as a greater reluctance to travel overseas), whereas the productivity enhancing changes will be maintained (such as spending online, the greater use of technology in the workplace). (See here.)

Table 3: Economy’s Supply Potential – Efficiency

Reasons to be Optimistic

Reasons to be Pessimistic

3. Efficiency
  • Firms hang onto innovative working practices.
  • Social distancing permanent.
  • Reduction in commuting, business travel.
  • Shorter supply chains.
  • Sectors hardest hit have lower productivity than average.

Source: Capital Economics

The issue of how much permanent economic scarring there will be is clearly a big and difficult question and we are still uncertain about how the pandemic will evolve let alone about what will follow. But all this gives us some hope that five years down the road, the UK economy stands a decent chance of getting broadly back to its pre-virus path. Mind you, the policy measures that the government takes next will probably prove just as important.

Implications of a fast and full recovery

If we are right in expecting the economy to recover more fully than most anticipate, then the economic consequences are threefold. First, there is potential for the unemployment rate to fall more quickly than it did after previous recessions. If the COVID-19 crisis is anything like the recession in the 1990s and in 2008, then even once the recession is technically over and the economy is expanding again, the unemployment rate will not start to fall back for at least two years. In the 1979 recession, it took nearly three years for the unemployment rate to start falling. (See Chart 7.)

Chart 7: Change in Unemployment Rate (ppts, Relative to Rate at End of Recession)

Sources: Refinitiv, Capital Economics

But if we are right in thinking that the economy will escape the crisis without much long-term scarring, then after peaking at 6.5% later this year, by 2022 the unemployment rate will be well on the way to returning to its pre-pandemic level of 4%. That would be not as bad as many other forecasters, such as the OBR, expect. (See Chart 8.)

Chart 8: ILO Unemployment Rate (%)

Sources: Refinitiv, OBR, BoE, Capital Economics

The second economic consequence is that the prevailing view that an additional dose of austerity is required to repair the fiscal damage caused by the crisis may be wrong. To reduce the budget deficit back to pre-virus levels, fiscal policy only needs to tighten if the economy suffers long-term scarring that means it is permanently smaller in the long run, thus causing a permanent reduction in tax receipts. (See here.)

Chart 9 shows the OBR’s projections for government borrowing as a percentage of GDP based on three scenarios. In the case that GDP is 6% lower in 2024/25 than its pre-crisis trend, the budget deficit would shrink to about 7% by 2024/25. But a 0% loss in GDP in 2024/25 would be consistent with the budget deficit returning to close to its pre-virus level of 2% by 2022/23.

Chart 9: Public Sector Net Borrowing (% of GDP)

Source: OBR

Our view is closer to the OBR’s upside scenario that assumes minimal scarring, meaning that the budget deficit returns to close to its pre-virus levels by the middle of the decade. And the rebound in GDP and record low interest rates will keep the debt to GDP ratio between 100% and 110% over the next five years.

This doesn’t mean that taxes won’t need to rise at all. But it suggests that they may need to do so only if the government wants spending to be higher than before the crisis, not to fill a hole in the public finances. Further ahead, fiscal policy would need to be tightened to counter the declining tax-take and rising spending burden from the ageing of the population.

The real danger is that a major tightening in fiscal policy over the next few years could undermine the recovery and create precisely the fiscal hole the Chancellor would be aiming to fill, preventing GDP from returning to its pre-crisis trend. So despite the grim warnings from the Chancellor, a fiscal tightening may be the last thing the economy needs right now.

The third consequence of a more complete recovery from the crisis is that it may eventually force the government to choose between either low inflation or looser fiscal policy. It cannot have both of these things at once in the long term.

Persistently high inflation isn’t likely to develop within the next year or two, not when the unemployment rate is still elevated. Admittedly, there may be a rise in the inflation rate this year, due to higher commodity prices and the end of the VAT cut for the hospitality sector. (See Chart 10.) On top of this, the recent surge in shipping costs may push up the price of imported manufactured goods. (See here.)

Chart 10: CPI Inflation (%)

Sources: Refinitiv, Capital Economics

But excess capacity in the economy will persist this year, meaning there will be substantial amounts of under-utilised resources that firms can draw upon to raise output during the recovery without putting upward pressure on prices. So as the temporary factors pushing inflation up this year wear off, we think in 2022 inflation will drop back to around 1.5%.

However, the threat of inflation picking up on a more sustained basis will become more significant thereafter if there is still a lot of policy stimulus sloshing around in the system when the economic recovery is well advanced. That’s especially the case as the huge policy stimulus has worked its way into the money holdings of households and businesses. In other words, it has ended up in the hands of those most likely to spend it. This is very different to the QE seen after the financial crisis when fiscal policy was more restrained, and the money ended up stuck in the financial sector. (See Chart 11.)

Chart 11: M4 Money Holdings (£bn)

Source: Refinitiv

If the policy regime remained the same, the Bank of England would raise interest rates to bring inflation down to 2%. But as higher interest rates would increase the public debt to GDP ratio, that would reduce the ability of the government to use fiscal policy to achieve its political aims.

Indeed, it only takes relatively small changes in interest rates to change the debt dynamics substantially. If after 2020, interest rates (or “r”) were 1 percentage point below nominal GDP growth (“g”), then debt will rise at a slower rate than GDP. Over time this means that the debt to GDP ratio would shrink naturally, reaching 90% after two decades. (See Chart 12.) Yet if interest rates exceed nominal GDP growth by 1 percentage point, the debt ratio would rise steadily to almost 130%. So the key point is that if interest rates were to rise significantly, then things could quickly get tricky for the government.

Chart 12: Stylised Example of Gov’t Debt As a % of GDP (Assuming Primary Budget is Balanced)

Source: Capital Economics

At that point, the government has two choices. It could respond by tightening fiscal policy via tax rises or spending cuts, so that the debt ratio doesn’t climb indefinitely. Or it could ensure that interest rates are kept low at the expense of low inflation, so that the debt ratio can at least be stabilised.

It is easy to see why the government might choose the second option. High inflation might seem like a price worth paying to keep running deficits even after the crisis is over. And it may be that central banks wish to take a deliberately more lax approach to inflation. The latest shift, being led by the US Fed, towards “average inflation targeting” paves the way for a period of overshoots of inflation targets after the current undershoots. The Fed’s move could turn out to be the thin end of the wedge.

So there could eventually be a more fundamental shake-up of inflation targeting, framed by governments and the central bank as improving the conduct of monetary policy. (See here.) This might involve raising the inflation target itself, or by putting more weight on other factors, such as GDP growth and/or climate change, but with the result nonetheless being lower interest rates and higher inflation than might otherwise be the case. Interest rates would probably still rise at some point. But we expect interest rates to stay low by historical standards. And we think the average inflation rate in the 2030s and 2040s will be above the current 2% inflation target. (See Chart 13.)

Chart 13: CPI Inflation & Policy Rate (%)

Sources: Refinitiv, Capital Economics

Conclusions

We think that the recovery from the crisis will be swifter and more complete than most expect. This suggests that the Bank won’t need to expand QE or use negative interest rates in 2021 or 2022. It also means fiscal policy won’t need to be tightened to fill a structural hole in the public finances.

Of course, there are risks to our upbeat view. A failure to bring the virus under control would tip more companies into insolvency and prolong the rise in unemployment. Policymakers could get it wrong, by withdrawing support or tightening policy prematurely and snuffing out the economic rebound we anticipate.

But the risks are not all to the downside. If there were a full run-down of households’ savings, then there is scope for a stronger spree in household spending. And the crisis could turn government policy in a helpful direction and prompt firms to undertake productivity-boosting measures quicker than they would otherwise have done.

Perhaps beyond the next couple of years, then, the legacy of the crisis might not be the permanently much smaller economy that most expect, but instead higher inflation and bigger public deficits.


Ruth Gregory, Senior UK Economist, +44(0) 7747 466 451, ruth.gregory@capitaleconomics.com