Former Bank of England Governor Mervyn King once said that the true meaning of the Christmas story will not be revealed until Easter, by which he meant that the lags in data releases mean that it takes a while before we can paint an accurate picture of what is going on in the economy. Although advances in real time data capture have significantly reduced the information lags, it is nonetheless the case that year-ahead forecasts produced in December often provide an inaccurate picture because they fail to incorporate events occurring at the end of the year. This is certainly true of the 2021 outlook which was derailed by the lockdowns which were intensified across Europe in early-January.
Here in the UK, the release last week of preliminary Q4 GDP estimates UK showed that the recent lockdown had a considerable impact on the growth profile. The monthly figures showed a contraction of 2.3% in November as lockdown conditions were reimposed followed by a rebound of 1.2% in December as they were eased slightly. Overall, fourth quarter growth came in at +1.0%. For 2020 as a whole, GDP declined by 9.9% which was the largest contraction since 1709 (when it declined by 13%). This was broadly in line with expectations formed last spring and did not come as any particular surprise. But a more intriguing question is how do we now view the outlook for 2021 in the wake of a tightening of lockdown conditions in January which will almost certainly have resulted in a sharp decline in activity last month?
One view of the world was put forward by the BoE whose latest forecast, released on 4 February, looks for a contraction of 4% for the first quarter of 2021. The BoE also expects a considerable rebound in activity in Q2 and Q3 with quarterly growth rates averaging around 5%, as the economy has “enormous amounts of pent-up financial energy waiting to be released, like a coiled spring” according to its chief economist Andy Haldane. To the extent that households engaged in a lot of involuntary saving in 2020 with the savings rate averaging around 16% versus an average of 9.4% between 1963 and 2019, he has a point. But my concern is that the psychological impacts of 2020 may be slower to fade with the result that saving over the next couple of years remains at elevated levels.
Looking closer at the detail
All told, the BoE expects GDP growth to average 5% in 2021 which is admittedly lower than the November 2020 forecast of 7¼% but for my money still feels a little bit on the high side. The National Institute (NIESR) shares this view with their latest forecast showing a GDP rebound of just 3.4% in 2021. These differences of view are not hugely far apart in the grand scheme of things, given the magnitude of the output collapse last year. In a bid to give my own assessment I have put together my own structural model of the UK to produce a medium-term outlook (the details of which are shown in the table below).
The BoE forecast suggests that output will reach pre-Covid levels by Q1 2022 whereas NIESR believes it will take until end-2023 to get back to these levels. History is on NIESR’s side. Following the major recessions of the past 50 years it has taken an average of 15 quarters for output to recover to pre-recession levels. My own forecast is pretty close to the NIESR projection with GDP forecast to reach the Q4 2019 peak in mid-2023. One of the reasons for my relative pessimism is I believe there will be a substantial degree of economic scarring that will hamper the pace of recovery – it is unlikely that we can simply flick the switch and the economy will get back to normal once the Covid crisis is over.
That said, the damage to the labour market may be rather more limited than I expected at the outset of the crisis. Latest labour figures suggest that the unemployment rate stands at only 5%: Back in the spring of 2020 I expected the jobless rate to be around 7% by year-end. This is due in large part to the fiscal support provided by the government which obviously has consequences for public finances (see below). I now look for a peak in the unemployment rate around 7% in late-2021, having at one stage expected it to reach 9%. Nonetheless, many businesses have struggled over the last 11 months, and assuming that we do start to see the economy opening up from Q2 onwards many of them will in effect have lost a full year of revenue. That is unlikely to be the sort of hit from which they can easily recover and my employment forecast suggests we will not get back to the pre-Covid peak in a hurry (chart).
Brexit poses additional challenges which are unique to the UK. Although we do not have much hard evidence to indicate the extent of the impact, there is plenty of anecdotal evidence which points to the difficulties facing export-oriented industries in particular. A recent report that the volume of exports going to the EU from British ports last month was 68% down on year-ago levels may overstate the impact which we can expect to see in the official data but it is clear that trade flows have been badly disrupted – and not all of it is due to Covid. Moreover, to the extent that leaving the EU single market will impose a long-term cost to the UK – NIESR estimates, for example, that it will reduce GDP levels by 3.5% in the longer run – this is another factor mitigating against those forecasts which look for a quick return to pre-Covid levels of output.
The public finance problem
One of the biggest consequences of the recent economic environment is the impact it will have on public finances. On the basis of evidence for the first nine months of fiscal year 2020-21, it is possible that public borrowing will come in rather lower than the £394bn projected by the OBR in December (for the record, my own forecast looks for a figure of £312bn or 14% of GDP). It ought to prove possible to reduce the deficit quite swiftly in the next couple of years as pandemic-related expenditure is cut back. In the medium-term, however, the pace of deficit reduction will not prove quite so easy with the result that on a five-year horizon it may prove difficult to get it back below 5% of GDP.
There has been a lot of concern expressed in recent months about the high level of public debt which the UK will have to carry post-Covid. Although the debt-to-GDP ratio now stands at 99.4% – the highest since the early-1960s – current debt levels are not out of line with historical experience with the debt ratio averaging around 100% of GDP over the past 300 years, and having reached a peak above 250% at the end of WWII. With a large chunk of the UK’s debt stock currently held by the BoE and continued strong demand for gilts in the primary market, we do not have to immediately worry about imposing fiscal austerity in order to bring public finances back into line. But in the next few years we will require a discussion about what measures the government will need to take (spoiler alert: it will require some form of tax rises rather than relying on spending cuts as was the case post-2008, a theme to which I will undoubtedly return).
Last word
Although my own projection paints a less rosy scenario than that of the BoE, as I have noted many times before the only thing we can say with certainty about any forecast is that it will be wrong (in whole or in part). I do not claim to have any unique insight that makes my own forecast “better” and the broad shape of the projection is similar to that of the BoE. But I maintain that the degree of scarring may mean that the recovery proves to be a slower affair. We do not fully understand the psychology of economic shocks. We are likely to learn a lot more in the coming years.
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