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March 26, 2021
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Tenreyro - Response to the Covid-19 pandemic: UK and US experiences

  • "The divergence between labour-market quantities and price inflation had been the source of debate about the slope of the price Phillips curve, the size of the output gap, and the level of full employment."
  • "In the MPC’s February 2021 forecast, UK GDP returned almost to its pre-Covid peak by the end of 2021, a much faster recovery than during the financial crisis. However, by the same point, the median FOMC member now anticipates that US GDP will be 4% above its earlier peak."
  • "the main cause of these vast differences in short-term developments has been the specific policy measures used to mitigate the economic damage from the pandemic in each country."
  • "the extent of scarring is itself likely to depend on both the fiscal and monetary policies in each economy."
  • "It is possible that paying generous unemployment benefits in a flexible labour market and while vacancies were at all-time lows had similar effects as the European furlough schemes did. Moreover, the relatively rapid recovery in US demand means that many workers who were not recalled may have less difficulty in finding new jobs."
  • "US micro evidence suggests that extra savings have been quite equally distributed across households of different income levels, and if anything have been slightly skewed towards lower income groups."
  • "recent survey evidence indicates that only 15% of UK households plan to spend more to catch up on previously unavailable services once the economy reopens, only slightly higher than was the case in January, and smaller than the amount of households who expect to spend less."
  • "The time horizon of the shock is likely to be important in influencing the effect of the policies on scarring. Individual defence – furloughing workers to maintain existing micro structures of employment – may be most likely to prevent scarring when the shock is temporary and does not lead to significant changes to consumer preferences and/or the structure of production. In that case, with less need for reallocation, matches are more likely to be maintained when furlough ends. The structure of the economy may also matter. For example, if labour markets are flexible, then zone defence – that is, providing generous social insurance and protecting household incomes to maintain demand – may enable employment to recover quickly, with less risk of scarring as a result."
  • "a key influence on the outlook will be the extension of the furlough scheme until the end of the third quarter, when all UK adults are expected to have been offered a vaccine. This has implications for demand, since it lowers the risk of a sharp rise in unemployment when the scheme ends. It also matters for supply, by reducing the risk of labour-market hysteresis. Recent expansionary US fiscal policy will also be important for the UK outlook."
  • "Despite the fiscal policy differences, I do not see a major divergence in long-term inflation risks across countries: monetary policymakers have the tools to contain and manage those risks, and would not hesitate to use them. All else equal, the greater fiscal boost in the US is likely to lead to a faster rise in the equilibrium rate of interest, r*, than in the UK."
  • "I would not consider a pick-up in inflation to be sustainable if it was due to transitory one-off effects, which are likely given recent rises in energy prices, as well as base effects from sharp falls in inflation at the onset of the pandemic. Moreover, it is possible that short-run supply could be somewhat constrained owing to production bottlenecks as the economy recovers, while current fiscal plans will lead to stronger demand in the near term, with weaker demand in future years. To the extent that these effects prove temporary, they would not imply any sustained pick-up in excess demand, nor in inflation, provided inflation expectations remain anchored."
  • "Despite lessening downside risks, there also remain a number of scenarios that I would anticipate requiring looser policy later this year... A delay or reversal in the relaxation of health restrictions, or renewed caution from households and businesses, would require more monetary support to help them bridge across to a period when health risks had been reduced. As always, the required loosening in monetary policy would also depend on the response of fiscal policy to any renewed economic weakness."

March 26, 2021
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Saunders - Supply and demand during and after the pandemic

  • "I put more weight on the risk that the central forecast in the February MPR overstated the temporary drop in potential output over the last year (and hence understated the extent of spare capacity in the economy at present) and was overly pessimistic on the path for potential output in the year ahead."
  • "the February MPR estimated that potential GDP in Q4-2020 was 7-8% below the Q4-2019 level and (given the further rise in restrictions and furlough) that potential GDP in Q1 would be about 11% down from Q4-19. The MPR forecast implies that these adverse effects on potential GDP are likely to be largely temporary... In the MPR, these persistent effects reduce potential output by 1¾% two or three years ahead compared to the pre-pandemic path."
  • "I find it hard to reconcile the top-down estimates that the output gap is modest and little changed over the last year with a range of other indicators which suggest that spare capacity in the economy has risen markedly over the last year."
  • "Weighted by firm size (number of employees), the share of firms reporting positive effects on productivity from remote working over the last year has been similar to the share reporting adverse effects"
  • "the contribution of furloughed staff to spare capacity (and potential output) may be higher than assumed in the February MPR."
  • "high unemployment tends to reduce pay growth irrespective of whether it is short- or long-term unemployment that is high. If rising long-term unemployment does not lift structural unemployment as much as implied by the MPR (if at all), then this would imply upside risks to potential output late this year and during next year relative to the MPR forecast."
  • "overall, my hunch is that the temporary adverse effects of the pandemic on potential output have been smaller, and will fade more quickly, than the MPR assumption."
  • "There are some upside possibilities for demand further ahead. For example, the household saving rate might fall faster over the next year or two than assumed in the MPR, reflecting pent-up demand as households run down a higher share of the stock of savings built up over the last year."
  • "roughly as many households report their savings have fallen as risen. The share of households reporting their savings have fallen is especially marked in the lower half of the income distribution, as well as among those who have been furloughed and self-employed workers. Moreover, the recent Budget increased the medium-term tightening in fiscal policy."
  • "Thus far, it is unclear whether, beyond Q2, upside or downside risks around the MPR forecast will dominate."
  • "the path of potential output is likely to be endogenous."
  • "it is useful to consider the shortfall of activity relative to the likely post-pandemic path for potential output once temporary effects fade, what one might call the efficient level of output. This shortfall probably is large now and is unlikely to close in the next few quarters. As long as this shortfall persists, it would be hard in my view to argue that the output gap has closed sustainably."
  • "In my view, that three-year ahead unemployment forecast (4½%) is likely to be a reasonable benchmark against which to judge whether activity has fully caught up with the path for post-pandemic potential output and hence closed the output gap sustainably."
  • "Risk management considerations also could apply, because an incomplete recovery and persistent output gap would be a more costly outcome than a scenario in which the output gap closes at an earlier date."

March 26, 2021
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HEW: Easter edition

  • The deluge of data out of the UK over the past week contained some substantial surprises as CPI inflation crashed and the unemployment rate dipped to 5%, where the latter is likely to be more relevant for the BoE (UK: labour market locked down tight). Although retail sales didn’t surprise us, we were interested to see signs of separate and underappreciated weakness in Mar-21 signals (UK: consumers stop feeling special). And taking the longer view, we explained why we still see Covid contributing to a disappointing GDP outlook for H2 and beyond (Covid-consensus is over-optimistic).
  • Next week brings a return of focus to the euro area and its flash inflation releases. Quarterly national accounts data for the UK could reveal some interesting details around the balance sheet damage from lockdowns but tend not to attract much market attention on the day.
  • In Heteronomics news, our website’s paywall will activate next week. So, if you haven’t already, please set your password using the link sent from system@heteronomics.com on Monday, request a reset through the login form, or reach out to us for assistance.