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What we learned from the Bank of England's verdict on the recovery

Diners eat outside the Ivy Market Grill, in London - Dominic Lipinski /PA
Diners eat outside the Ivy Market Grill, in London - Dominic Lipinski /PA

Three months ago, the Bank of England would not even make a forecast about the economy.

Such was the sheer scale of the pandemic and the lockdown’s impact, that the City of London’s greatest financial institution was not prepared to nail its flag to any particular numbers.

Instead it came up with a “scenario” to give an idea of the crunch. But that was in May.

Now Andrew Bailey and his economists have gathered enough information to piece together a forecast, and it is remarkably chirpy - at least by the standards of this most unusual of years.

This is what we learned from August’s Monetary Policy Report.

V-shape

When the coronavirus struck, economists hoped the recession would follow a “V-shape”, meaning a rapid crash in GDP as the economy was locked down, then an equally rapid recovery as everyone got back to normal once more.

As the depth, length and severity of the pandemic became clear, this gave way to fears of a much longer and more painful crunch.

Yet now the economy is opening up once more, the Bank of England appears hopeful that something like a V-shape could take place.

The reopening has resulted in a strong rebound in some parts of the economy.

Consumer spending is back within 10pc of its “usual” levels, up from a drop of 30pc to 40pc at the height of lockdown.

The housing market has “returned to close to normal levels” already.

Most furloughed staff are back at work, the Bank estimates, while the number paid to stay at home at any one point in time peaked in May at somewhere north of 7m, rather than the 9.4m jobs that have been furloughed at some stage altogether.

The Bank now estimates that GDP dropped by just over 20pc from peak to trough, rather than almost 30pc anticipated in its May scenario.

That translates to a fall in GDP of 9.5pc over 2020 as a whole, rather than 14pc as sketched out in May.

But when the bigger drop was expected to be followed by a 15pc rebound in 2021, now the rise is expected to be just 9pc, indicating a lop-sided “V”, taking a little longer to return the economy to its pre-Covid size.

Nonetheless, this is a relatively cheery picture compared to many other forecasts from different economists.

Sunak and Bailey vs coronavirus
Sunak and Bailey vs coronavirus

Damage

The struggle to get back to old levels of output comes in two key parts.

Firstly, it will take time for demand to recover. People are still worried about coronavirus and will not all return to life as normal. On top of that, those who lose, or fear losing, their jobs, will cut spending.

Secondly, the underlying capacity of the economy is taking a hit. Not every business will recover. Not every industry will retain its place.

With lower investment, innovation and reallocation of capital from inefficient firms to stronger businesses, the Bank expects the capacity of the economy will still be 1.5pc lower at the end of its three-year forecast than before the outbreak struck.

Joblessness will be another indicator of this, with higher unemployment meaning lower output as workers are not being put to good use.

The Bank expects unemployment to hit 7.5pc this year, which is less severe than in the financial crisis and short of the 9pc previously anticipated, but still a fearsome increase from below 4pc before Covid-19 arrived.

It will fall to 6pc next year and only come close to pre-pandemic levels at 4.5pc in 2022.

Negative rates

This forecast is positive, but still shows a major hit to the economy.

Plenty of analysts say it is too optimistic. Kallum Pickering at Berenberg Bank, for instance, says it will take until 2023 before the economy gets back to its late 2019 size - more than a year after the Bank of England says GDP will pass this benchmark.

George Buckley at Nomura calls it “too optimistic”.

So what more can the Bank do to get the economy out of this hole? And how will it react if growth does recover more slowly than expected?

Negative interest rates could be one answer.

This subverts the usual “rules” by which one pays to borrow money and earns interest on savings, in an extraordinary effort to encourage borrowing and spending.

The Bank’s analysis in the Monetary Policy Report listed a series of reasons why this could be a bad idea, indicating it is not on the agenda yet.

“Banks’ balance sheets will be negatively affected by the period of severe economic disruption arising from Covid-19. And they have an important role to play in helping the UK economy recover by providing finance for individuals and companies,” the Bank said. “As a result, negative policy rates at this time could be less effective as a tool to stimulate the economy.”

Yet Bailey indicated it is already in the Bank’s “toolkit”, indicating it is ready for use if and when he deems it appropriate.

He said it might be best to go sub-zero during the recovery, rather than at the peak of a crisis.

Economists at Citi expect the Bank to take rates to zero in November, add another £50bn to quantitative easing, and then go negative in 2021.

Keep on lending

Banks are under clear instructions to keep on lending.

They are facing credit losses of up to £80bn, as some businesses and households will struggle to repay their debts, but the Financial Policy Committee told lenders they still have plenty of capacity to dish out loans.

“By restricting lending, [defensive] actions could make the central outlook materially worse,” officials warned.

But this is why banks have built up capital buffers since the financial crisis: to enable more lending in a recession.

Indeed, the Bank of England estimates banks could handle a recession twice as big as this, based on last year’s stress tests of their financial buffers.

On top of that, family finances are in a better position than they were going into the credit crunch.

More pressingly, the Bank wants to ensure financial markets can handle big economic shocks without having to rely on enormous injections of liquidity such as that seen in March.

“These interventions can pose risks to public funds and can encourage excessive risk-taking by investors. There must be an appropriate balance between private sector resilience and reliance on central bank liquidity support,” the committee said.

Although tensions have calmed in recent months, “underlying vulnerabilities remain and disruption could resurface in the face of certain triggers. Risky asset prices could correct sharply if the economic outlook changes. There could also be an amplified tightening of credit conditions in the event of a large wave of downgrades of corporate bonds or leveraged loans.”

That points to potential risks for big businesses and the institutions which lend to them.