The UK government and Bank of England have launched a coordinated response to Covid-19, unprecedented in the era of central bank independence. 
The BoE pre-empted the Chancellor of the Exchequer Rishi Sunak’s Budget address with a widely anticipated half-point cut in interest rates to 0.25 per cent, but it announced much more besides. All three of its policy committees agreed to provide a bridge for UK businesses and households across the economic disruption, help avoid longer-lasting economic harm, and increase the likelihood that the recovery, whenever it comes, will be V-shaped.
This was followed by Chancellor’s announcement of the largest sustained stimulus since Norman Lamont’s pre-election budget in 1992.
Additional BoE stimulus
Additional measures included the introduction of a new funding facility for commercial banks. This provides cheap financing over four years to help banks pass on the headline cut in interest rates to household and business borrowing without hurting their margins. The Bank’s analysis suggests this could provide in excess of £100bn in funding, targeted at small- and medium-sized enterprises (SMEs). The BoE will also make loans available to banks in all major currencies on a weekly basis. Around £300bn could potentially be borrowed through these facilities.
Additional support will be provided through a reduction of the countercyclical capital buffer. This ensures that commercial banks build up sufficient capital in good times so that they don’t need to hoard capital in bad times. The minimum capital requirement, on top of which the countercyclical buffer sits, together with bank stress testing, ensures banks still have enough capital should the economy go into recession. The BoE has waived the need for banks to retain this buffer, allowing them to lend more, with immediate effect. This could support up to £190bn of bank lending, or 13 times net lending to UK businesses in 2019.
Yields on shorter-dated gilts fell a couple of basis points, while longer-dated yields rose a little. We interpret that as a good sign, suggesting market confidence that the central bank’s measures will help.
Largest giveaway since 1992
The Chancellor announced a budget stimulus worth £30bn in year one. £12bn of this is designed to combat disruption from Covid-19, and is largely directed towards tax and rates relief for small businesses.
Stimulus not linked to the virus is largely directed towards departmental expenditure and investment. There will be an extra 0.5 per cent of GDP of regular departmental spending in 2020-21 relative to the March 2019 budget, rising to an extra 1.2 per cent GDP in 2023-4. But real departmental spending per person will only get back to 2010 levels in 2024-25. For the Chancellor to claim the Conservatives are the party of public spending is rather disingenuous – a number of departments, such as the Ministry of Justice, have had to manage cuts of over 30 per cent in inflation-adjusted terms, and the Budget won’t unwind them by much.
Investment spending
We welcome a focus on investment spending, although we await the spending review to assess by how much it could boost potential growth. Investment spending will rise by £6.8bn in 2020-21, and another £23.2bn by 2023-24. Most investment is linked directly to government departments: on a per capita basis this will increase to 35 per cent above 2010 levels by 2024-25.
Large sums will be devoted to transport and fast broadband connectivity nationwide. This is good: infrastructure projects tend to have large ‘fiscal multipliers’ meaning they can pay for themselves over the long run.
We would like to see significant funding for a long-term strategy to deal with the systemic changes of the digital economy. There are few ‘spill-overs’ from business investment these days, particularly the intangible investments of the new economy. Historically, economies have grown by firms learning from each other, but that doesn’t seem to happen much anymore, particularly in the UK. To help productivity growth recover, the government must focus on innovation and knowledge-based strategies. From that point of view it’s pleasing to see that research and development investment will increase to 2.4 per cent of GDP, the highest in nearly 40 years.
The lip service paid to green investment was very disappointing. The evidence is quite clear: climate change is a material risk to the economy and financial sector. The government needs to facilitate more investment in a green-energy revolution. And it’s not just a matter of mitigating a threat: large productivity bursts over the last 250 years have often been linked to lower energy costs, so there’s also opportunity here.
Funding the giveaway
The Budget has been financed in part with the direct fiscal savings associated with Brexit and by cancelling the corporation tax cut that was due in April.
But tax receipts will rise a little too. Revenue from income tax and National Insurance contributions will go up by 0.7 per cent of GDP during this Parliament because unchanged personal allowance and higher rate thresholds mean more people will be dragged into higher tax bands. Capital taxes are boosted from 2021-22 onwards by curtailment of entrepreneurs’ relief. This is good news, there is no evidence this relief actually encourages entrepreneurialism.
But the huge new spending will be financed mainly through higher borrowing.
Obeying the fiscal rules
The Chancellor claims his Budget allows government policy to obey the fiscal rules set by his predecessor. But this is only because the £12bn dedicated to combatting Covid-19 hasn’t been included in the Office for Budget Responsibility’s (OBR) calculations. Neither has the OBR adjusted down its estimates of GDP growth for the virus. This will almost certainly mean that the large budget surplus forecast for 2022-23 will turn into a large deficit when it is accounted for. Even without it, government borrowing is set to increase far more than set out in March 2019’s forecast. Impishly, we might say that the Chancellor has shaken that ‘magic money tree’. Does it matter? You could think of Covid-19 stimulus as akin to an extraordinary item in a company’s accounts. It is widely accepted that it is prudent to give dispensation to the treatment of special, one-off costs. Accounts, by their very nature are a stylised version of reality. Nevertheless, that special cost does need to be reflected on the balance sheet one day.
Contrary to popular opinion, governments with their own mints can spend as much money as they want. The government’s ability to finance itself is constrained only by inflation. It collects taxes and issues debt as a form of demand management in order to keep inflation expectations contained.
If inflation expectations remain low, a government with its own currency can run deficits ad infinitum.
These measures, which come at a time when there is a risk of a deflationary bust, are unlikely to un-anchor inflation expectations, so we aren’t concerned about their impact on the deficit. What matters most is the credibility of our institutions. Monetary and fiscal policy must make credible commitments to attend to inflation expectations and not resort to currency debasement. But these credible commitments need not involve balanced budgets. This government maintains that credible commitment.
Does this change the outlook?
Excluding the virus-related stimulus, the OBR expects the economy to grow by just 1.1 per cent in 2020, even with the purse strings significantly loosened. This shows what a weak state the UK economy is in. Indeed, we think that may be a bit optimistic (again, before taking into account Covid-19), due to the persistent weakness since 2017, the dismal GDP data for January 2020, and the lack of a rise in investment intentions seen in surveys of firms after the general election but before the outbreak of Covid-19 in China.
Assessing the impact of Covid-19 itself and the related stimulus is extremely difficult. On balance, the extra stimulus announced today is likely to be offset by the cost of the disruption.
Gilt yields and interest rate expectations were little changed following the Chancellor’s speech. The pound weakened a touch, but that could be due to the general risk-off move in global markets. The more pertinent question for investors is: will the EU and the US do more to stimulate the economy?
Ed Smith is head of asset allocation research at Rathbones. The views expressed above are his own and should not be taken as investment advice.