Brexit breaks

After paying a heavy toll to the Covid 19 pandemic, the UK is getting back on its feet. Now that more than 80% of the adult population has been vaccinated, the UK economy was able to reopen for business this summer and to operate almost normally despite the spread of the highly contagious Delta variant. Just as the recovery is running up against supply-side constraints, the government of Boris Johnson is removing fiscal support measures as it proclaims the end of “whatever the cost”. Euphoric so far, the recovery should calm down somewhat by the end of the year.

The UK is finally getting back on its feet. Covid-19 was initially brushed aside by Prime Minister Boris Johnson before forcing the government to implement ever tighter restrictions. The pandemic triggered the worst recession in UK history (2020 GDP plummeted 9.8%) and caused 135,000 deaths, one of the heaviest tolls of the advanced economies.

Now that more than 80% of the adult population has been vaccinated, the UK is finally exiting the crisis. Though still in the grips of the Delta variant, which is 40-60% more contagious than its predecessor, the “English” variant (renamed Alpha), the hospital system has reported only a mild upturn in severe cases (with at most 800 hospital admissions daily, down from nearly 4,000 at the height of the previous wave). With the reopening of business in phases since February, the economy has rebounded spectacularly, and has rapidly encountered supply-side constraints.

Supply side constraints, rising inflation

Q2 2021 not only marked the end of a strict lockdown – it was even more severe than the one introduced during the first wave of the pandemic in spring 2020 – but was also a period of catharsis, during which British consumption surged at an annualised rate of more than 30%, and businesses bounced back, easily erasing the losses earlier in the year.

As in other countries where households benefited from massive support measures, curbing/restraintson spending led to the build-up of surplus savings, which are now flowing back into the economy (chart 2). Indeed, demand is so strong that supply is struggling to keep up: in transportation, construction and throughout supply chains, delivery periods are getting longer and bottlenecks are forming. Companies are experiencing hiring troubles, even in recovering sectors like tourism and leisure, where job vacancies have reached record highs.

Of course, this is not a specifically British problem. It can be found just about anywhere due to a global shortage of components (Asia, the main supplier, is still struggling with the virus), congested maritime traffic, and commodity market pressures by China and the US.

Yet in the UK, supply-side constraints have been exacerbated by Brexit, whose harmful effects are already palpable. With the return of immigration barriers to keep out European Union workers (visas, work permits, etc.), the obstacles to hiring and the recovery are not only cyclical. According to the Confederation of British Industry, the labour shortage could last two years.

These tensions are now carrying over to prices. At 3.2% in August, inflation has beaten the odds and soared to the highest level since 2012. Some base effects are to blame: the acceleration in inflation in August 2021 can be attributed in part (for 0.3 points) to the fact that prices are compared to the very low levels of August 2020, which is notably when the government launched its “Eat Out to Help Out” scheme that allowed bars and restaurants to propose discounted meals under certain conditions. However, the surge can also be attributed to the fact that many leisure and recreational activities -like hotels or restaurants - still operating at reduced capacity, were given no choice but to raise prices to meet the inflow of customers. The lifting of lockdown restrictions is also illustrated by strong pricing pressures on cars, notably used cars, much like the situation observed a few months ago in the United States.

With the upcoming VAT hikes (see below), the Bank of England (BoE) expects inflation to reach 4% by the end of the year, largely surpassing its 2% target. This inflationary surge is nonetheless expected to be short- lived, and the central bank does not intend to raise its base rate, currently set at 0.10%, until the economy has fully recovered. That condition has not been met yet. Although midway through 2021, economic activity is nearing pre-pandemic levels, there is still a shortfall of a little over 4 points of GDP. Yet closing the remaining gap is likely to be much harder, since the Johnson government plans to begin removing fiscal support measures this fall and to raise social welfare contributions in April 2022.

The end of “whatever the costs”

In the UK, like in most of the “liberal” advanced economies (such as the US, Canada and Australia), public support measures deployed during the health crisis have helped offset the relative weakness of social welfare shock absorbers. They have proved to play a vital role. According to estimates by the International Monetary Fund (IMF), the UK injected no less than GBP 340 billion (16 points of GDP) into the economy in 2020-21, a record for Europe. Although “whatever the cost” is no longer fully justified, its removal will nonetheless serve as a test case.

Fiscal support measures have already begun to be withdrawn. At the end of September, the government ended its main job retention schemes, namely the Coronavirus Job Retention Scheme (CJRS) and the Self-Employed Income Support Scheme (SEISS).

Introduced in March and April 2020, these two programmes benefited roughly 14.5 million workers (payroll employees and the self-employed) and largely helped reduce the rise in unemployment, which barely rose above 5% at the height of the crisis. As the economy has recovered, these schemes have been allowed to expire. But for the 1.6 million employees still furloughed in their companies, this could prove to be a difficult awakening.

If the current labour shortage can facilitate the transition, things do not stop there. In addition to the job subsidies, the GBP20-a-week boost to universal credit was also eliminated for some 6 million British citizens. Moreover, all households will be hit by the increase in the reduced VAT rate for hotel and restaurant services (to rise from 5% to 12.5% in October 2021, then to 20% in April 2022). And the stamp duty holiday was reduced from GBP 500,000 to GBP 250,000 in July, and will be slashed to GBP 125,000 in October.