How does Covid-19 affect economic activity and inflation?

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Published on 08 June 2020

Covid-19, and the public health measures to contain it, temporarily reduce spending and production, and those effects can be amplified by factors such as increased uncertainty. Their impact on inflation is uncertain.

The Bank of England’s Monetary Policy Committee set out the channels through which Covid-19 affects the economy in chapter three of the May Monetary Policy Report.

Covid-19 and the public health measures put in place to contain its spread, such as social distancing, temporarily reduce economic activity as firms and households are unable to produce and spend as they usually would (Figure 1). Weaker global economic activity adds to these effects, reducing export demand and disrupting international supply chains. Firm revenue and household income fall as a result.

Figure 1 Covid-19 affects economic activity through a series of channels

Increased uncertainty, lower confidence and a tightening in financial and credit conditions can amplify the initial falls in spending and production. For example, households may save more as a precaution and some firms may make lay-offs and sell capital equipment. While activity should recover as social distancing measures are lifted, there could be longer-lasting ‘scarring’ effects on the economy, although exceptional action by governments and central banks to ease the severity of the downturn should help to limit this.

The balance of these effects on supply and demand will partly determine the impact of Covid-19 on inflation. The impact is very uncertain, given the sharp changes in demand, the partial closure of some industries and significant differences in experiences across sectors. The impact of spare capacity may be less than usual. During periods of weak demand, increased slack might not be fully reflected in lower costs for firms, if some fixed costs such as rent remain unchanged, for example. Firms are also likely to be less able to generate increased demand through price cuts as consumers are less able and willing to spend, reducing the incentive to lower prices. External cost pressures, such as movements in the exchange rate and commodity prices, will also influence inflation.

This post has been prepared with the help of Nickie Shadbolt and colleagues in the Monetary Policy Outlook and Structural Economics Divisions.

This analysis was presented to the Monetary Policy Committee as part of its May 2020 round.

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