UK AUTHORITIES IMPLEMENT UNPRECEDENTED MEASURES AS COVID-19 THREATENS GLOBAL ECONOMIC ACTIVITY
The sudden restrictions on activity due to the Covid-19 pandemic will have a significant effect on the economy. PwC recently forecast a fall in GDP across 2020 of between 3 and 7%, with a rebound in 2021. However it is difficult to be precise as it is not clear how long the pandemic has to run, how businesses and households will respond, nor how the world will be different when we come out of the crisis. It is akin to a natural disaster, but nationwide and longer lasting. Restrictions to personal freedoms are likely to last in some form for at least the next six months.
This is unlike previous recessions when demand and/or supply are hit by a shock, as instead we have a self-induced shut-down of the economy in all but essential sectors, with the Government stepping in to support exposed businesses and households on an unprecedented scale to try make them ready for recovery in order to reduce the long-run impact. The labour market is key – the more businesses survive and people keep their jobs, the stronger and faster the recovery will be, hence the Chancellor’s focus on subsidising furloughed employees and the self-employed. The Bank of England has also focused support on SMEs and corporates, and the Treasury has launched £330 billion of loans and grants.
Unfortunately none of these channels will be perfect, and many people will see their incomes drop or lose their jobs, as indicated by 950,000 people reportedly signing up for Universal Credit in the last two weeks of March, more than nine times the usual number. The fear of a loss of income will cause consumers more broadly to defer spending. Uncertainty will also stymie business investment. Results from a flash UK purchasing managers’ survey give an indication of the impact on the economy. In March, the index (where anything under 50 suggests a recession) fell drastically to 37 from 53 in February.
To support demand the MPC voted to cut the Bank Rate twice in two weeks; to 0.25% on 11 March, and then to a historic low of 0.10% on 19 March. The Bank has previously said this was the lowest Bank Rate could effectively go. In addition a new Term Funding scheme with additional incentives for Small and Medium-sized Enterprises (TFSME), financed by the issuance of central bank reserves was launched. The MPC voted to increase the Bank’s holdings of UK government bonds and sterling non-financial investment-grade corporate bonds by £200 billion to a total of £645 billion, financed by the issuance of central bank reserves, and said it stands ready to buy more. Compared to the quantitative easing in the wake of the financial crisis, this round of monetary stimulus is considerably larger and is not being introduced over a number of months, but immediately.
It remains to be seen if the package of support will be sufficient to support those affected, and the Chancellor has committed to do “whatever it takes”. Other unconventional policy proposals that may yet be considered include negative interest rates (so far rejected by the Bank, but in place in other countries, and the TFSME would presumably then pay rather than charge a fee on drawings), the Bank working in coordination with HM Treasury to buy newly issued government debt, or even cash transfers direct to households.
The Bank has said that it will monitor the pass-through of its Bank Rate cuts to market interest rates, supported by its new funding scheme, TFSME. Data from a sample of societies show asset yields and costs of funds prior to the recent cuts in Bank Rate, showing that margins had been maintained through the second half of last year (see chart). Previous Bank of England funding schemes have tended to bolster margins by reducing funding costs relative to mortgage rates. Rates on both sides of the book will fall as the cuts to Bank Rate feed through, but it remains to be seen how far, particularly as the 0.10% level is unprecedented. At the time of writing, the average reduction in SVRs that have been announced by building societies is a little over 50bps.
The most recent data shows CPI annual inflation was 1.7% in February, down from 1.8% in January. The Covid-19 pandemic will damage both supply and demand in the economy, the extent to which they fall relative to each other will determine the inflationary impact. In the short term, the supply shock will be severe, pushing up inflationary pressures, and the fall in sterling may also see the prices of imports rise, adding to this pressure. This will however be offset by the fall in demand, and the fall in oil prices.
Longer term, when we are through the worst of the pandemic and restrictions are being lifted, it is unclear whether more support will be needed to boost spending, or conversely, if what is already in place will prove excessive as firms restart production. One view is that there will be considerable inflation after the recovery. The cash injections will support pent-up demand once we are released from lock down, and the supply capacity of the economy may well be damaged, with firms having gone out of business. How much the resulting inflation would be tolerated would have to balance how highly indebted households (particularly after repayment holidays) and businesses could cope with higher interest rates, against the distributional impact on savers and pensioners as higher inflation erodes their spending power.
However, if there is diminished confidence or ongoing uncertainty once restrictions are lifted, for example if there is a possibility of the virus returning and lockdown restarting, even more support for demand may be needed. There is also likely to need to be more support for those borrowers for whom the disruption to their incomes is long-lasting. As well as reviving schemes from the wake of the financial crisis, such as making Support for Mortgage Interest more generous and Mortgage Guarantees, there may need to be more innovative policy solutions, such as Government providing guarantees to support challenges in valuing assets. State involvement in markets is unlikely to fall away quickly.
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