Lockdown sparks major Sunak U-turn and BoE action

The Bank of England’s (BoE) Monetary Policy Committee (MPC) decided to keep interest rates on hold at 0.1% today, but to increase its purchases of government bonds by an additional £150 billion over the next year – more than consensus estimates by economists had anticipated. The increase in quantitative easing (QE) is in response to new Covid-19 restrictions being introduced across the UK, which it predicts will cause the economy to contract in the final quarter of this year.

Later in the day, Chancellor Rishi Sunak effectively caved in to pressures from opposition politicians by performing possibly one of the most expensive policy U-turns the Treasury has ever seen. Sunak announced the extension of the costly and inflexible Coronavirus Jobs Retention Scheme, which was due to end this month, and be replaced by a more cost effective and flexible system of short-hours working. Instead, fully furloughed workers will retain 80% of their income up to £2,500 per month until the end of March at an estimated cost of £5 billion per month.

Sunak said he will review the policy in January to see if it needed to be adjusted, though it is unlikely to be scaled back significantly, especially when you have a central bank ready to monetise debt on order.

In addition to the rate decision, the BoE published its Monetary Policy Report for November, in which it presented its updated forecasts. Real GDP growth has been downgraded for 2020 from -9.5% to -11%, and from +9% to +7.25% for 2021. However, the forecast for 2022 has been upgraded from 3.5% to 6.25%, suggesting a delay to the recovery. Reduced household spending is the primary drag on growth in the forecast, assumed to be caused by restrictions on retail rather than a worse outlook for the labour market.

The household saving ratio has been revised up by a percentage point (ppt) to 15.25% for this year and to 10.75% (3.5ppt increase) for 2021. Meanwhile, the forecast for the unemployment rate for Q4 2020 was reduced from 7.5% to 6.25%, but raised from 6% to 6.75% for Q4 2021, with a smaller upward revision for 2022, albeit with a falling trend as the economy recovers.

CPI inflation is forecast to remain close to 0.5% in the near-future, but averaging 2% in 2021, 2022 and 2023. The BoE sees spare capacity in the near term offsetting higher energy inflation contributions in 2021, but that offset switching places from 2022 onwards.

The forecast is conditioned on the MPC’s assumption that the UK will strike a free trade agreement with the European Union. However, its surveying of businesses suggests that even with such an agreement, some companies are still not ready for the transition, and that some disruption, especially at ports, should be expected. This has now been factored in to the BoE’s assumptions.

Questions continue over whether the MPC will eventually take interest rates below zero as priced by financial markets. The message from the committee, however, remains that the operational impediments for negative interest rates to work effectively have not been resolved, and there are questions over its efficacy. Indeed, when comparing the BoE’s forecasts using the constant interest rate (0.1%) and the negative rates assumed by the market, there is hardly any difference in the growth and inflation projections.

Overall, very few surprises form the Bank of England’s assessment of the state of the economy, but disappointing to see the Chancellor cave to pressure on the furlough scheme. As confirmed by the Bank, additional QE is not expected to boost growth, but it is needed to stop a tightening of financial conditions. This is policy speak for: to prevent panic in gilt markets.