New Covid strain means short-term prospects for UK economy are bleak

The sharp fall in share prices in the City told its own story. Hopes that the arrival of 2021 would see a bounce in the economy after a year to forget have been dashed. The new mutation of the virus that causes Covid-19 will put strains on the NHS and has disrupted Christmas plans for millions. It will also delay recovery from the biggest peacetime collapse in growth in more than 300 years.

The introduction of tough tier 4 restrictions for London and most of the south-east of England means that the bounce expected in the first three months of next year is now unlikely to happen this side of Easter.

Theoretically, there is a possibility that the restrictions, which have to be reconsidered on a regular basis, might be eased quickly. That looks unrealistic because since Boris Johnson’s announcement at the weekend, the message from ministers has been that the curbs on activity will probably remain in place for months rather than weeks.

As a result, the short-term prospects for the economy are bleak. Growth is going to be slower and public borrowing – already on course to be close to £400bn in the current financial year – will be higher.

An indication of how quickly things have deteriorated can be gauged from the forecasts prepared by the Bank of England and the Office for Budget Responsibility only last month. At the beginning of November, the Bank assumed that when the four-week lockdown in England ended on 2 December, restrictions on activity would return to their level in October. On that basis, Threadneedle Street expected output to pick up in the first three months of 2021 and to return to its pre-crisis level by early 2022.

The OBR adopted a different approach in the forecasts it prepared for Rishi Sunak’s spending statement at the end of November, presenting three different scenarios.

Its central case was that pre-lockdown tier 3-type restrictions for England would apply to the UK as a whole until the spring and that by the end of the first quarter of 2021 the economy would be just 10% smaller than it was pre-Covid.

An upside scenario envisaged tier 2-style restrictions, in which case national output would be just 4% down on its pre-crisis level, while a downside scenario saw the possibility of high infection rates necessitating “very stringent” curbs on activity in place for the winter.

These, the OBR speculated, would be somewhere between England’s tier 3 restrictions and the November lockdown and would result in the economy being 14% smaller than it was at the start of 2020. The gloomiest of the scenarios now looks the likeliest of the three and the economy is bound to take a hit as a result.

Whether the damage is as bad as the OBR fears remains to be seen. Its assumption that the November lockdown will have caused a 7% drop in monthly output may prove to be too pessimistic, with signs that retail spending migrated online and that businesses had become more pandemic resistant as a result of lessons learned in the spring.

That said, there are clearly downside risks. For many hospitality businesses that have survived so far, a third period of closure might be the final straw. Despite the decision to extend the furlough scheme until the end of April, rising unemployment could dent consumer confidence. It is possible that vaccines could prove ineffective against new strains of the virus.

But for now, recovery would appear to have been postponed to a later date rather than abandoned altogether. One reason for that is that the vaccination programme will be stepped up over the coming months. A second is that both the Treasury and the Bank of England have made it clear that they intend to continue supporting activity. Interest rates will remain low and there will be no austerity measures in the budget.

The big unknown is how people respond to what will inevitably be a tough winter. Will they be too scared to leave their homes or will they be desperate to have a good time with friends and family?

If the latter is more typical, the economy could go off like a rocket.

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