Brightening outlook reduces the need for tax hikes - Capital Economics
UK Economics

Brightening outlook reduces the need for tax hikes

UK Economics Weekly
Written by Ruth Gregory

With the positive news on COVID-19 vaccines brightening the economic outlook, we now think that by the middle of the decade the economy won’t be much smaller than if the COVID-19 crisis had never happened. Admittedly, there are two big risks, namely the possibility of an “uncooperative” no deal Brexit and a substantial early fiscal tightening. But provided the politicians don’t mess it up, we think that the economy should do better than most think.

Webinar Invite: The European outlook – From lockdowns to vaccines

Thursday, 3 December

Chief Europe Economist Andrew Kenningham will lead this special briefing with colleagues Jessica Hinds, Jack Allen-Reynolds and David Oxley to discuss Europe’s economy under lockdown. The team will preview the ECB’s December meeting, assess Sweden’s attempts to control the pandemic, and look ahead to the potential economic impact of vaccines in 2021. Complimentary registration here.

Following the news on 9th November that the Pfizer and BioNTech COVID-19 vaccine is very effective, we highlighted how this could dramatically improve the economic outlook. (See here.) Since then, the positive news on other vaccines has convinced us to formally assume within our forecasts that effective vaccines are widely available from Q2/Q3 next year, allowing most of the COVID-19 restrictions to be lifted.

As a result, we now think that GDP will return to its pre-virus level in Q1 2022, rather than in 2023. And we expect the economy to return to its pre-crisis trend a few years later. That would be a much better result than most expect. (See here.)

Admittedly, the vaccines will come too late to prevent the economy from contracting in Q4. 99% of England’s population will still be under tight restrictions when the lockdown ends on 2nd December. So while the restrictions will be looser than in November, they will still be more stringent than they were back in October. As such, we still expect GDP to fall by 3.5% q/q in Q4.

And the two main downside risks to the outlook have not disappeared. First, an “uncooperative” no deal Brexit, which could have lasting implications for the economy. (See here.)

Second, there is a growing risk of a substantial early fiscal consolidation. Admittedly, the Chancellor, Rishi Sunak, this week announced a welcome increase in COVID-related spending of £55bn (2.4% of GDP) in 2021/22. That’s on top of the £280bn (14.5% of GDP) of fiscal support so far.

But beyond 2021, the Chancellor has already started to claw some money back, saving £10bn to £12bn a year from departments’ non-COVID budgets. And the new forecasts published by the Office for Budget Responsibility (OBR) show that the economy could still be 3% below its pre-pandemic trend by the end of 2024/25. That is consistent with tax rises, or spending cuts, of up to £48bn a year, or 2.1% of GDP.

But we’re not at all convinced that an immediate fiscal consolidation is necessary. Such action will hurt the economy and ironically could mean that any eventual fiscal consolidation would have to be greater.

Much depends on the economy’s ability to grow over the next few years. And the OBR’s upside scenario (which is closer to our own forecast) shows just how much difference a decent recovery makes to the budget deficit. (See Chart 1.)

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

Sources: OBR, Capital Economics

Indeed, for our part, we do not think that the economy will be smaller forever more. (See here.) This suggests that the government does not need to tighten fiscal policy to return the deficit to the sort of levels seen before the crisis. What’s more, very low borrowing costs for the foreseeable future means that the government can tolerate a far higher debt burden than in the past.

Overall, we think that the economic outlook beyond the next six months is better than most forecasters currently expect, provided of course the politicians don’t mess it up!

The week ahead

We suspect that MPC member Silvana Tenreyro will hint in a speech on Monday that the good news on vaccines has taken further monetary policy loosening off the table, and that the markets are wrong to continue to price in the possibility of negative rates over the next two years.


Economic Diary & Forecasts

Upcoming Events & Data Releases

Date

Country

Release/Indicator/Event

Time (GMT)

Previous*

Consensus*

CE Forecasts*

Data Response

Mon 30th

UK

M4 Money Supply (Oct)

(09.30)

+0.9%(+12.3%)

DR

UK

Net Consumer Credit (Oct)

(09.30)

-£0.6bn

+£0.2bn

+£0.2bn

DR

UK

Mortgage Approvals (Oct)

(09.30)

+91.5k

+82.0k

+88.0k

DR

UK

MPC’s Tenreyro speaks on monetary policy

(14.30)

Tue 1st

UK

Nationwide House Prices (Nov)

(07.00)

+0.8%(+5.8%)

+0.0%(+5.2%)

+0.7%(+6.0%)

UK

IHS Markit/CIPS Manufacturing (Nov, Final)

(09.30)

55.2p

55.2

55.2

UK

OBR Chair testifies to Treasury Committee

(09.30)

Wed 2nd

UK

BRC Shop Price Index (Nov)

(00.01)

+1.2%(-1.2%)

Thu 3rd

UK

IHS/CIPS Composite PMI (Nov, Final)

(09.30)

47.4p

47.4

47.4

UK

IHS Markit/CIPS Services PMI (Nov, Final)

(09.30)

45.8p

45.8

45.8

Fri 4th

UK

IHS Markit/CIPS All-Sector PMI (Nov)

(09.30)

52.2

48.0

UK

IHS Markit/CIPS Construction PMI (Nov)

(09.30)

53.1

51.3

51.3

Selected future data releases and events

Thu 10th

UK

GDP (Oct, m/m(y/y))

(07.00)

+1.1%(-8.5%)

DR

UK

Services Output (Oct)

(07.00)

+1.0%(-8.6%)

DR

UK

Industrial Production (Oct)

(07.00)

+0.5%(-6.3%)

DR

UK

Construction Output (Oct)

(07.00)

+2.9%(-10.0%)

DR

UK

International Trade Balance (Oct)

(07.00)

+£0.6bn

DR

*m/m(y/y) unless otherwise stated

Sources: Bloomberg, Capital Economics

Main Economic & Market Forecasts*

%q/q(%y/y) unless stated

Latest

Q1 2020

Q2 2020

Q3 2020

Q4 2020

2019

2020

2021

2022

GDP

+15.5(-9.6) (Q3)

-2.5(-2.1)

-19.8(-21.5)

+15.5(-9.6)

-3.5(-12.9)

(+1.3)

(-11.5)

(+7.5)

(+7.5)

CPI inflation

(+0.7) (Oct.)

(+1.7)

(+0.6)

(+0.6)

(+0.7)

(+1.8)

(+0.9)

(+1.6)

(+1.7)

ILO unemployment rate (%)

4.8 (Sep)

4.0

4.1

4.8

5.2

3.8

4.5

6.3

4.8

Bank rate, end period (%)

0.10

0.10

0.10

0.10

0.10

0.75

0.10

0.10

0.10

10 yr gilt, end period (%)

0.30

0.39

0.18

0.25

0.50

0.83

0.50

0.50

0.50

$/£, end period

1.34

1.24

1.25

1.29

1.35

1.33

1.35

1.40

1.45

Euro/£, end period

1.12

1.14

1.14

1.14

1.13

1.18

1.13

1.12

1.12

Sources: Capital Economics, Refinitiv

* Assumes that severe COVID-19 restrictions are in place during November, December and January and that lighter, diminishing, restrictions are in place in February, March and April and vaccines are widely available from Q2/Q3. (See here.) Assumes the UK and EU agree a slim trade in goods deal by the end of the year. (See here.)


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