By Jeffrey Matsu, CIPFA Chief Economist
The future has never been less clear. With neither a vaccination nor consistently effective treatment near at hand, and limited understanding of how COVID-19 might evolve, policy makers are caught in another high stakes game of roulette. As if contending with Brexit wasn’t enough, economic models have simply collapsed under the sheer weight of uncertainty facing the UK. Indeed, recent official forecasts have euphemistically been rebadged as “scenarios” based on ever tenuous assumptions. Reader beware.
If it is to be believed at face value, the prognosis could be far worse. In an “illustrative scenario” of what might happen, the Bank of England now expects UK GDP to fall by 25% in Q2 2020 to end the full year down 14% before recovering sharply by +15% in 2021. Similarly, the Office for Budget Responsibility (OBR) in its reference scenario expects a grimmer reading of -35% for Q2 but with a quick turnaround in Q3 of +25% to end 2020 with an annual growth rate of -13%. GDP in 2021 would be +18%. The Bank and OBR assume that the government’s lockdown rules are largely maintained during Q2 and gradually reduced over the subsequent quarter. A further, rather heroic, assumption is made that the UK moves to a comprehensive free trade agreement with the EU on 1 January 2021. Long-term negative effects on the economy are largely avoided in either assessment as it is also assumed that public health restrictions, and not the virus itself, account for a majority of the fall in GDP.
At the best of times, GDP is considered a lagging indicator prone to sizeable revisions. During the depths of a recession, measurement issues boil to the surface revolving around methodology, data collection and conceptual challenges on how to account for government support schemes such as the furlough subsidy. As mundane as it may sound, adequately capturing the sudden change in economic activity matters because it informs our understanding of second-round effects that percolate through the economy both today and into the future. Central government grants, local government spending and the ability to generate revenue are all inextricably linked to economic output and performance.
Unlike most recessions that are triggered by an internally generated shock, COVID-19 is unusual in that it affects both economic supply and demand simultaneously. Ascertaining how prices will respond during the economic recovery depends largely on how consumers and firms behave, which at this point is anyone’s guess. According to the Bank of England, a combination of higher spare capacity and low oil prices will bring CPI inflation to a near-standstill by the end of 2020 before rising modestly to 0.7% next year and 2% by 2022. This contrasts with the OBR’s more hawkish view that CPI returns to its pre-crisis path rather sooner reaching 2.3% in 2021. In the absence of a sudden and persistent surge in inflation, the bank is likely to maintain its accommodative policy stance for some time to come.
Labour markets will be particularly sensitive to changes in policy support measures. The recent extension of the Coronavirus Job Retention Scheme for an additional four months will help workers and businesses adjust to the transition away from lockdown, but will not prevent job losses or insolvencies thereafter. With the unemployment rate expected to more than double from 4% pre-crisis to 9% in Q2, targeted policies that encourage the reallocation of resources from high to low capacity sectors will ensure that labour and skills are utilised efficiently. Industries with a high concentration of self-employment, such as construction, as well as those businesses in sectors that will be last to reopen, will invariably require extended support as well. Meanwhile, the roll-out of rapid worker retraining and further investments in workforce development programmes should form a central component of the post-virus recovery strategy.
The cost of current government support measures could exceed a staggering £300bn. According to the OBR’s analysis, public sector net borrowing rises to 15% of GDP in 2020-21, a £244bn increase from its Spring Budget forecast and the highest since World War II. Additional quantitative easing coupled with the Bank of England’s new Term Funding Scheme also feed into higher public debt, which rises to 96% of GDP this year compared with 80% in 2018-19. Unlike the deficit which falls back quickly after the policy stimulus ends, debt is envisaged to remain stable but elevated until 2024. In either case, the fiscal impacts are deemed to be sharper but shorter in duration than those experienced during the financial crisis of 2008.
What do all these numbers mean and how likely are the outcomes? Epidemiological unknowns aside, much will depend on how quickly the economy returns to its pre-crisis path or whether scarring leads to more structural impairments to growth. There is scope for optimism in that the UK economy is in far better shape than in past downturns with fewer internal balances or excesses to address. Of course, this says nothing about how the recovery will intersect with the timing of Brexit.
Given these circumstances, perhaps the greatest risk to the economic outlook would be a policy error in withdrawing support too soon.
This article first appeared in Public Finance.