What were you doing on the eve of the pandemic? That may be easy to recall. But what were you doing in early 2014? That may take a bit more time to work out. Why do I ask?
Well, at the end of March the economy is likely to be back at the level of activity it saw in the first half of 2014. Moreover, by the beginning of next year, I expect the UK to have returned to where it was on the eve of this pandemic, as the ending of lockdown is followed by a strong rebound.
So, over the next ten months, we could witness the equivalent of six years of economic growth. Even though those may have been years of only modest growth, that is still a strong rebound, by any measure. It will continue into next year, too.
Many factors dictate the outlook
The outlook for the economy this year depends upon many factors, including: an easing of the health crisis that will be the trigger for the economy to emerge from its economic crisis; on how cautious or optimistic people and firms are as the economy recovers; and on keeping taxes and interest rates low.
The health situation, while poor, is improving significantly with a fall in infections, hospital admissions and deaths and the UK’s highly successful vaccination roll-out. As the Prime Minister has indicated, he wishes to avoid another lockdown, hence he is proceeding cautiously, unlocking in stages until, on current plans, full reopening occurs on 21st June.
The economy’s performance during the pandemic gives insights into what may lie ahead. The economy collapsed last March and April and then, as the initial lockdown ended, recovered from May onwards, albeit with vast differences.
Some areas weathered the pandemic well, such as large parts of the service sector, or even boomed, such as online retail. Many people had no fear of losing their job and, also, excess savings reached £125 billion by last November and are likely to have risen further since.
In contrast, swathes of the economy have suffered badly. This was evident in rising unemployment, the fall in payrolls (particularly for the young and unqualified) and was also seen in the collapse of activities across a number of sectors, from the arts to tourism.
The current lockdown may trigger a contraction this quarter, but it is likely to be far less than was initially feared, perhaps down by under 2%, before it then starts to recover from the spring.
Amid the rebound, inevitable uncertainty will persist
Although unlocking will help the economy rebound, there are considerable uncertainties. Some people may still be sensitive to any bad news linked to the virus, particularly ahead of next winter. There are likely to be changes in behaviour and not a return to pre-crisis norms, impacting travel, work and spending patterns.
On the upside, the opening-up will trigger more activity and probably a burst in consumption this summer in social activities, as the different stages of unlocking proceed. However, it is unclear whether those with excess savings will spend freely, or whether firms with healthy balance sheets will invest.
On the downside it is unclear where unemployment will peak. Now over 1.7 million, a rise to just under 3 million is possible. Another concern is the high debts being borne by many small firms, as these will limit their ability to grow. Policy could help in both these areas. Phasing out furlough until after the economy has recovered and business confidence has risen may limit the loss of jobs, while writing off the government backed loans to small firms may be an option, helping them bounce back.
Also unclear is how supply chains will have survived this pandemic. This may lead to bottlenecks, particularly if demand rebounds strongly. In turn, this will feed uncertainty about inflation over the next year or two. At 0.7% now, it will rise as reductions in VAT for certain services and softer energy prices triggered by the pandemic are reversed. Beyond the post-pandemic rebound, the same structural influences evident in recent years should keep inflation low.
Despite uncertainty, recovery is inevitable, helped by unconventional and unlimited monetary and fiscal policies. Both are working hand-in-hand together, with the mammoth quantitative easing (QE) by the Bank of England suppressing gilt yields, making it cheaper for the Government to borrow and fund its huge deficit.
I expect monetary policy to remain accommodative for some time, with policy rates low and unchanged through this year and next. The Bank’s buying of gilts looks set to continue until the autumn before it achieves its £895 billion QE target. By then, too, the Bank will have negative interest rates as part of its tool-kit, but the economy’s likely rebound suggests they will not be needed, or used.
The fiscal judgement
In the imminent Budget the challenge for the Chancellor is that the economic and political cycles are not aligned.
With the next General Election only three years away, politics may suggest tightening sooner, rather than later. If he was looking for past lessons, the Chancellor might bear in mind the 1981 Budget, when fiscal policy was tightened, against economic opinion, as highlighted by a critical letter that 364 economists then sent to The Times. The economy recovered.
In contrast to the politics, economic factors suggest a strong case for a neutral stance in this Budget.
Moreover, the Chancellor should avoid any new fiscal rules, as previous ones have lacked credibility and not stood the test of time. If anything, the focus should be on a set of fiscal principles, aimed at helping the economy recover, while achieving sound public finances.
Given the uncertainties ahead, premature fiscal tightening should be avoided. Low debt servicing costs present the Chancellor with ample fiscal space. Indeed, in the US, in similar circumstances the authorities are, to use their words, spending big. The possibility that yields here may rise slightly this year, as the economy recovers, should not force the Chancellor’s hand just yet.
Instead, the focus should be on support, not on stimulus. The UK economy does not need an additional stimulus, given its likely rebound, but one focus of the Budget should be on helping the economy adjust to the ongoing effects of this economic shock. Targeted support will clearly be needed to some sectors and to certain groups of people.
While Government spending measures unveiled to address the pandemic will likely be scaled back over the coming year, austerity and a squeeze on public spending are not on the agenda. Instead, with low yields, higher infrastructure spending has already been unveiled, and is justified.
The Budget’s tax challenges
In the Budget, therefore, the focus will be on taxes. There is a need to differentiate between the direction of travel versus specific measures. Adjustments to the tax system to make it more coherent are always welcome at any time, but one question is to what extent the Chancellor will see this Budget as a first stage in recouping revenues to close the budget gap. I don’t think he should.
The Government appears committed to lower taxes in future, while their 2019 election manifesto ruled out hikes of major taxes such as income tax, national insurance or VAT.
Ideally the Chancellor should: cut stamp duty on housing, but instead could reintroduce measures to help buyers; offer further help to firms over business rates; and ideally taper rates for some benefits and allowances that create high marginal tax rates.
Instead, the talk is of: reversing the previous commitment to cut corporation tax and to raise it either now or later this fiscal year, while still keeping it at a low level internationally; of raising capital gains tax; possibly phasing out higher rate relief on pensions, as this is least economically damaging, but would take a few years to execute; and of freezing personal income-tax allowances.
Recovery will allow the budget deficit to improve significantly over the next year. But there will still then be a large budget deficit. One economic view, often heard, is to see that deficit and the outlook for the fiscal numbers as signalling a structural budget gap to be closed by large tax rises.
That is not my view. Instead, I would advocate focusing on reducing the ratio of debt to GDP gradually, underpinned by the pursuit of a market-friendly, pro-growth economic policy. Such growth is also needed to allow the economy to fund high quality public services.
I have called for such a pro-growth strategy to be based on the three arrows of: a credible fiscal stance; monetary and financial stability, perhaps with a new remit for the Bank of England; and a supply-side agenda focused on all the “I’s” of boosting infrastructure, innovation, investment and incentives and reducing inequality.
Please note, the value of your investments can go down as well as up.