The Bank of England’s August Monetary Policy Report – ‘So Far, So V’

The Bank of England’s May Monetary Policy Report was the first to incorporate the impact of COVID-19 on the UK’s economy. The Bank forecast a V-shaped recovery with economic activity plunging steeply, bottoming out in Q2 and then recovering strongly in the second half of 2020. With the expected recovery being less rapid than the fall, it was not a pure V-shape but more of a ‘lopsided V’. Despite scepticism towards the lopsided V-shaped recovery, on the 30 June the Bank’s chief economist Andy Haldane gave a speech supporting the view, stating that his reading of the evidence was ‘so far, so V’.

Just over a month after that speech was given, and following the release of its August Monetary Policy Report, does the Bank of England still think things are ‘so far, so V’?

Does the recent BOE GDP forecast provide hope?

The short answer is yes. The August Monetary Policy Report’s central case remains one of recovery but at a slower pace than the earlier falls: a lopsided recovery. There are differences to the May projections, however. Now, the Bank’s central projection of UK GDP is a decline of 9.5% in 2020, a significant improvement on the 14.5% fall pencilled in in May’s report. This reflects the Bank’s view that the recovery since March’s lockdown has been more rapid than expected in their May projections. Almost giving with one hand the Bank takes away with another. The Bank now anticipates a slightly slower recovery in 2021 because of persistence in unemployment, with UK GDP expected to be below its 2019 Q4 level until the end of 2021, compared with mid-2021 in the May forecast.

While this is a slightly less optimistic recovery than had been projected in May, should we be worried? In our opinion, not really. The lopsided recovery has been the CBRE House View since April and remains so. It also remains far more positive than the central case put forward by the OBR in its Fiscal Sustainability Report, in which GDP was forecast to be below its 2019 Q4 level until mid-2022.

Source: Bank of England, CBRE Research, August 2020.

Why a Lopsided V?

The Bank highlights three main reasons for the lopsided V-shaped recovery. Firstly, the Bank now expects elevated uncertainty surrounding health risks and job security to persist into 2021 and to decline only gradually. Because of this they expect spending to remain weaker than it would’ve been in the absence of COVID-19. Secondly, although unemployment is forecast to be lower than in May, labour market mismatch means that hiring will be slower than assumed in May, causing unemployment to persist at higher levels until 2021 before slowly recovering. Finally, weaker business investment will result in lower productivity growth which is going to have long-lasting scarring effects on potential GDP growth.

How does the BoE central case differ from the OBR’s?

The Bank (like CBRE) appear to have placed much greater weight on what high frequency data implies for recent months and on what this implies for the pace of the recovery in the second half of the year. As a consequence, they now expect a much stronger recovery in the second half of the year. To take an example, in Q3 2020 the Bank expects GDP growth of 18.3% vs the OBR’s 8.9%. Because of this, the Bank is also much more optimistic for 2020 as whole (-9.5% vs -12.4% OBR). This relative optimism is mirrored in their projections for employment. Like CBRE, the Bank now expects the stronger H2 recovery to support labour demand, resulting in the majority of the furloughed workers returning to work once the scheme ends in October. In contrast, the OBR’s weaker H2 recovery results in a much larger spike in unemployment in 2020 (12.4% vs the Bank’s 7.5%) and a much slower decline. This persistent unemployment causes scarring and a much more gradual recovery than assumed in the Bank (and CBRE) case. The uneven nature of the recovery and the potential impact of uncertainty on companies’ retention and hiring decisions, however, still means that it is difficult to be precise about where unemployment will be at the end of the year even if GDP does recover as expected.

Source: Bank of England, Office for Budget Responsibility, August 2020.

What about inflation, interest rates and monetary policy?

Despite their relative optimism about the economic recovery, the Bank’s CPI inflation central projection acknowledges that inflation is likely to remain persistently below the target, falling to 0.25% in the second half of 2020. Rising unemployment, softening wage growth, falling energy prices and temporary cuts to VAT in the hospitality sector are the perfect cocktail for a softening of general price pressures. Given these projections, At the August MPC meeting, the MPC voted unanimously to keep Bank Rate at 0.1% and continue with the existing asset purchase program at a target stock of £745bn.

Surprisingly, however, the Bank’s market-based projections showed the short-term interest rate going negative late in 2021. These refer to short-term market rates, which are already close to zero, rather than Bank Rate. As they are so low already, a fall is unlikely to be effective at increasing interest-sensitive spending and may actually have adverse effects on the banking sector, although the evidence is mixed. Nevertheless, lower-for-longer interest rates and continued asset purchases remain good news for property, an asset class that isn’t reliant on direct central bank interference and still maintains an attractive spread on risk-free and corporate bond yields.