The U.K. economy shrank less than expected in January during a coronavirus lockdown, driven by a surprise gain in construction and stronger activity in the health sector.

Gross domestic product fell 2.9% after a gain of 1.2% in December, the Office for National Statistics said Friday. Economists had forecast a 4.9% drop. The economy is now 9% smaller than it was in February 2020 before the pandemic struck.

Better Than Expected

U.K. economy shrank less than forecast in January as construction unexpectedly rose

Source: Office for National Statistics

The reading will feed into the Bank of Englands decision next week on whether the U.K. needs more stimulus to recover from the biggest slump in three centuries. Prime Minister Boris Johnson is hoping his rapid vaccination campaign will allow most restrictions to be lifted by the middle of the year.

Increases in health services from both vaccine rollout and increased testing partially offset the declines in other industries, Deputy National Statistician for Economic Statistics Jonathan Athow said in a statement.

Manufacturing and services contracted but the construction industry posted a gain, with output 0.9% higher than in December. Construction was the biggest drag on GDP in December, when most other parts of the economy posted increases.

A 3.5% drop in services was less than economists had forecast. It was driven by the accommodation and food services and education sectors, where output dropped 28% and 16.3% respectively.

Health and social work activity provided the biggest boost for the month. Real estate and information communication also increased in the month. A category that includes hairdressers and other personal services fell almost 21%.

Brexit and Trade

The U.K.s first batch of official trade data since leaving the European Union exposed the damage done to the flow of goods and services by Brexit in January. Exports to the EU fell 40.7% from December to January, while imports to the bloc dropped 28.8%. The hardest hit EU imports were machinery and transport equipment, especially cars and medicinal and pharmaceutical products.

Both imports and exports to the EU fell markedly in January with much of this likely the result of temporary factors, Athow said. Returns from our more timely surveys and other indicators suggest trading began to recover towards the end of the month.

For now, the governments official forecaster, the Office for Budget Responsibility, expects a 3.8% drop in output this quarter followed by a quick recovery to pre-Covid levels in the second quarter of next year, six months earlier than it had forecast in November.

The Bank of England is even more upbeat, predicting a return to end-2019 levels by the start of 2022 after a 14% surge in output over the preceding year, though Governor Andrew Bailey warned earlier this month that the risks to the economy are tilted to the downside.

Scarring Effect

The U.K. economy is not expected to return to its pre-pandemic path

Source: Office for Budget Responsibility, Bank of England

Note: 4Q 2019 = 100

The pandemic is still likely to leave scars on the economy, with implications for everything from unemployment to the eventual tax rises or spending cuts needed to repair the public finances.

Under the main scenario drawn up by the OBR, output is around 3% lower in the medium term than it would be had the pandemic not happened. The BOE estimates the long-term hit at around 1.75%.

With assistance by Camomile Shumba, and Lizzy Burden

(Updates with details from the statement from the first paragraph.)

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