Premium: Covid-19’s short-term impact will be greater than financial crisis

The spread of coronavirus and the public health response has upended economists’ previous view of where the UK economy was heading. Social distancing measures and government lockdowns on many businesses will cause significant disruption to activity in the short-term, particularly in sectors like restaurants and bars where spending usually takes place in crowded areas (such ‘social consumption’ accounts for 40 percent of total household spending).

So, consumer spending, the most important part of the economy, is set to drop significantly in the short-term. Meanwhile, the closure of schools for most children will prevent many parents from working, and with some individuals ‘self-isolating’ but unable to work from home, plus a higher incidence of sickness, the supply capacity of the economy will be hit.

The decline in activity in Q2 2020 is likely to exceed the quarterly contractions in the economy seen in the global financial crisis of 2008-2009. We expect GDP to fall by around three percent in the first half of 2020, and by 1.4 percent in 2020 overall, as the economy endures a sizeable shock to supply and demand.

However, we expect the economy to rebound strongly towards the end of 2020. Evidence from previous pandemics, including SARS in 2002/03 and the Spanish flu in 1918/19, suggest that most activity tends to be delayed rather than destroyed entirely, while the boost to real incomes from the plunge in oil prices over recent weeks and policy support from the government and Bank of England will help activity to return to normal.

The recent sharp depreciation of sterling and the UK’s large tax wedge mean that it will benefit less from falling oil prices than many other economies. Still, our modelling suggests that the price of a litre of petrol should drop to around £1 over the next month from £1.30 at the start of the year, which should mean that CPI inflation slows sharply to under 0.5 percent in the summer.

The bank’s Monetary Policy Committee has cut the official interest rate to a record low of 0.1 percent and has restarted quantitative easing with £200bn of asset purchases, consisting of gilts and private sector securities. It has also introduced a new Term Funding Scheme with additional incentives for small businesses, which aims to ensure a full pass-through of the rate cuts.

"With no obvious historical precedents, it is very difficult to forecast what happens next"

Policymakers have implemented a number of measures aimed at sustaining the supply of credit. And commercial lenders have also announced a three-month mortgage holiday for people affected by coronavirus.

But these moves are likely to prove of secondary importance to the scale and nature of the fiscal response. The centrepiece is an open-ended commitment from the government to provide grants covering 80 percent of the wages of workers at risk of losing their jobs as a result of coronavirus-related disruption, up to a total of £2,500 per employee per month.

We estimate that this scheme alone could cost around £18bn over the three months to June, equivalent to almost one percent of annual GDP.

In addition, all businesses will see their VAT payments in Q2 deferred until the end of the financial year at a (temporary) cost to the exchequer of £30bn, the welfare budget has been boosted, including greater coverage for the self-employed, and the BoE has said that it will provide large firms with unlimited loans. In total, government borrowing is likely to rise to, or even exceed, the post-war record of 10 percent of GDP seen in 2009/10.

As to what this means for demand for credit, a temporary period of hibernation, alongside much of the wider economy, is likely. Demand for loans is likely to plunge in the short-term, as people are unable or unwilling to spend, particularly on big-ticket purchases. But ultra-low interest rates and government support suggest that the scale of defaults is likely to fall well short of what a major recession would normally entail.

A period of stagnant activity looks in prospect, with a bounce back once the period of crisis response has passed.

That said, there is a huge degree of uncertainty surrounding where the economy is headed over the next few months. With no obvious historical precedents, it is very difficult to forecast what happens next. Countries could be more seriously affected, the impacts longer lasting and the financial market spillovers greater than hoped. We view this scenario as a plausible alternative baseline which, if the situation continues to deteriorate, could become our central view in the coming months.