Western Europe July 21, 2021 / 01:21 pm UTC

UK Spare Capacity and the BoE: Scarring vs Bruising

By Andrew Wroblewski
  • Bank of England policy thinking is in a state of flux as the Monetary Policy Committee (MPC) recoils from a series of higher-than expected inflation outcomes. Two policy members are already considering some earlier tightening, and even those keener to keep policy on hold also implicitly accept that spare capacity in the economy may have shrunk. We accept that the economy may now be hitting some supply constraints, largely a result of global trade COVID-induced disruptions restraining imports, and that these may be more sizable in the UK compared to other DM economies, largely a result of the size and nature of UK external trade. 
  • Bottom line: As a result, and compared to previous cycles, it seems that the UK trade deficit in goods has fallen and thus not absorbed the recovery in demand seen of late. Indeed, instead of a rise in net imports, higher prices have resulted and particularly for goods. But such problems (such as a shortage of sea containers) are unlikely to persist. In this regard, the damage to the economy’s potential growth rate may be better understood as COVID bruising rather than longer-lasting scarring.
  • Implications: While it may still take months for global supply chains to be repaired, UK import growth should recover into 2022, partly as Brexit difficulties ease but also due to an expected reversal of the unusual divergence with GDP growth (Figure 1). This may thus add to the supply side of the economy, acting as a further pressure valve to ease price pressures should demand strength persist. However, and in line with our existing thinking, demand growth may instead ebb into next year, not least on the back of the anticipated recovery in import volumes.

Figure 1: Imports Lagging behind Overall UK Economic Recovery

Source: ONS, Continuum Economics

UK More Vulnerable to Global Supply Chain Problems

The manner in which global supply chain problems are besetting the international economy are sizable and broad-ranging. They include chip shortages shutting car plants, shipping delays and container shortages (or at least mismatches), all adding to rising costs and output delays. As for shipping, freight costs along the world’s busiest routes have soared both because of logjams and a shortage of the 40-foot steel containers that carry the bulk of the world’s exports. It is estimated that there are some 25 million such containers, each making (in a normal year) some 8-9 trips annually. These cost pressures are expected to dissipate as vaccinations, and the ensuing relaxation of restrictions, prompt a shift in DM household behavior from spending on Asian-made consumer goods to spending on services. 

While container shipping mismatches are expected to remain higher than before the crisis, they are unlikely to stay at their current levels. But even though they have not prevented world trade from regaining its pre-pandemic footing, they have caused clear damage, particularly to island economies such as the UK, where 95% of overall external trade (and 75% in volume terms) is conducted via the country’s maritime ports. This compares to the EU, where on average only half of extra-EU trade is done via sea. Alongside the supply problems facing the shipping industry that is vital to the UK’s ability to trade alluded to above, this may explain why UK imports are still so weak, although the impact of Brexit and the end of the transition period last December almost certainly have added to the UK’s trading woes, albeit more in hampering exports than imports (1). Regardless, it is evident that despite a clear recovery, UK import levels are still far behind pre-pandemic levels, a clear contrast to the EU (Figure 2) and global trade generally.

Figure 2: UK Goods Imports Faring Poorly Compared to the EZ

Source: Eurostat; ONS, Continuum Economics

Trade Gap Not Acting as Usual Cyclical Demand Safety Valve

This is important as in any single economy, the inflationary repercussions of periods of strong(er) demand growth can be offset by a widening trade gap. This is especially the case for the UK, for which exports account for 58% of GDP, over twice the proportion of that of the EU, where half of its trade is within the union. But as Figure 1 also illustrates, in the current cycle, strong demand has not been accompanied by stronger imports. Indeed, instead of an expected fresh worsening of its chronic goods trade gap, the latter has continued to narrow, and at £8.5bn in May was the smallest in over a year. This almost certainly is a result of an inability to import, related to the COVID-induced supply problems discussed above. Importantly, this reduced ability (as opposed to willingness) to import helps explain at least some of the rise in CPI inflation, especially as that rise has been largely confined to goods (Figure 3) and it is in regard to goods imports that the shortfall in trade has been clearest. 

Figure 3: CPI Jump Largely Confined to Goods

Source: ONS, Continuum Economics

Import Recovery to Slow GDP Growth and Soften Inflation

Equally importantly, as (shipping) supply problems ease, as we expect into 2022, imports will recover. This will have two important effects. Firstly, and reversing what may have occurred over recent months, this effective increase in supply will help soften price pressures on goods. This is one of the reasons why we share the widespread view that the UK inflation rise seen of late will be a spike: Although CPI inflation may approach 4% by the end of the year (it is actually over 4% once changes in taxes are excluded, i.e. the so-called CPIY), it may fall back below the 2% target by end-2022.

Secondly, as imports detract from GDP, a rise in imports will also act to soften GDP growth, reversing what may have been a statistical boost to recorded growth in the past few quarters. This is one reason, along with fiscal tightening and fragile confidence as pandemic worries persist, why we see the economy slowing to a below consensus 5% in 2022 from nearly 7% in 2021.

This import ‘shortfall’ may be only part of the story regarding the supply side of the economy. After all, and as BoE estimates suggest, the scale of the supply drop last year was unprecedented, as is the scale of the anticipated recovery this year (Figure 4). The UK may have more protracted problems regarding falling job vacancies while Brexit will weigh on an already-weak productivity trend. Indeed, these may be more genuine and sizable scars than ones that COVID may cause. But given the temporary nature of the supply disruptions that COVID has caused, the harm to the economy from the import shortfall may be better described as bruising than scarring.

Figure 4: Unprecedented Swings on the Supply Side

Source: BoE, four-quarter growth % change in estimated potential supply

  1. There are of course risks that the Brexit factor may continue to hamper UK trade, especially if the current tensions over the Northern Ireland protocol intensify. But this is more likely to damage exports than imports.
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I, Andrew Wroblewski, the lead analyst certify that the views expressed herein are mine and are clear, fair and not misleading at the time of publication. They have not been influenced by any relationship, either a personal relationship of mine or a relationship of the firm, to any entity described or referred to herein nor to any client of Continuum Economics nor has any inducement been received in relation to those views. I further certify that in the preparation and publication of this report I have at all times followed all relevant Continuum Economics compliance protocols including those reasonably seeking to prevent the receipt or misuse of material non-public information.