Q: Paul, there's growing optimism about the speed of the UK's recovery. Do you think it will last?
A: Yes. At the start of the crisis most forecasters were slow to cotton on to how far GDP would fall and, more recently, they've been a bit slow to realise how quickly it will rebound. I suspect that the next forecasting trend is that people will follow our lead in concluding there won’t be much long-term economic scarring. In other words, the future level and growth rate of GDP won’t be much lower because of the pandemic.
Q: What does this forecast mean for the inflation and monetary policy outlook?
A: It’s crucial because if the economy’s supply-side hasn’t been damaged by the pandemic, then demand can be stronger for longer without generating inflation. That doesn’t mean there won’t be pockets of inflation. Energy inflation is soaring and there will probably be some “reopening inflation” in those sectors that were shut during lockdowns. But if supply hasn’t been damaged by the pandemic, then those bursts of inflation will probably be temporary. That’s why we think the markets are wrong to assume the Bank of England will start to remove the punchbowl in late 2022. We think policy won’t be tightened until 2024.
Q: When the Bank finally does get round to it, how will it tighten policy?
A: Most people assume that it will raise interest rates first and start to unwind quantitative easing (QE) much later. But the Bank is keen to give itself the ability in future to unleash large amounts of QE to quash any dysfunction in the financial markets, just as it did when the pandemic struck in March last year. We don’t know for sure, but we're increasingly thinking that the Bank will start to unwind QE before it raises interest rates.
Q: Does it matter?
A: Not when it comes to the wider economy because, whatever policy mix it uses, the Bank will try to tailor the dose to hit the 2% inflation target. But it could be a big deal for the financial markets. Usually when interest rates are about to rise the gilt yield curve rises and flattens. That’s because the markets’ expectations for interest rates over the next few years rise by more than expectations further out. But if QE is unwound first, then the gilt yield curve may rise and steepen. That’s because near-term yields would be anchored by interest rates staying lower for longer and longer-term yields would be boosted by a decrease in the Bank’s demand for gilts of longer maturities.
Q: What about fiscal policy? How does a fast and full economic recovery influence future government tax and spending decisions?
A: The general perception is that, at some point, either taxes will need to be raised or government spending will need to be cut in order to significantly reduce the budget deficit. But if we are right in expecting GDP to return to its pre-pandemic path, then the resulting rise in tax receipts will reduce the deficit naturally. That means the Chancellor may be able to cancel the hikes in corporation tax scheduled for 2023.
Published 18th May, 2021