Last year household consumption slowed sharply. In nominal (cash) terms, spending rose 3.9%, which was the smallest annual increase in more than 50 years. The explanation was straightforward: at the start of the year average earnings were rising at a rate of 4.5%; by the end of the year this had slowed to 3.5% and unemployment was rising — there simply was not the cash about to underwrite higher spending.
At the same time consumer price inflation picked up from 1.5% to 2.5%, which added to the squeeze. Spending in real terms was caught in the pincers of less cash and more inflation so that growth slowed from 3.5% in 2004 to 1.3% in 2005, the weakest annual growth since the present recovery got going in 1992.
By the end of the year, helped by lower interest rates and rising employment, there were signs of a recovery in demand. We raised our game for Christmas, upping our spending by 0.8% in the quarter to produce a 1.6% surge in retail sales volumes. We returned after Christmas with something of a hangover and retail spending dropped 1.6% in January and 0.5% in the first quarter. But it was up again in the second quarter by a cracking 2% as the World Cup boosted spending in a number of key areas, such as plasma television sets and the food and drink that is an essential accompaniment to watching football.
When the MPC cut base rate in August 2005 the weakness of consumer spending was uppermost in its mind. A year later, in reversing that move, the committee was able to report that “household spending appears to have recovered from its post-Christmas dip”. In the MPC’s eyes only “a small part” of the increase was related to the World Cup and the unusually hot weather; rather more of it reflected an increase in the underlying rate of spending. A modest rate hike would not do serious damage to consumer demand that the MPC sees rising at only a little less than its long-term average of 2.75% over the coming two years.
The MPC recognises that there are significant risks to that forecast. An upside risk is that the momentum we saw in the second quarter is maintained in the near term. The (bigger) downside risk is that the World Cup boost was much larger than the MPC estimates and that, with a renewed squeeze on household incomes, the outlook is for a return to the weakness that we saw last year. July’s 0.3% drop in retail sales may be no more than a reversal of the World Cup effect but it does suggest that momentum is slowing.
Advertisement
It is hard to argue that the recent resilience of consumer demand was underpinned by income. There has been a modest rise in the rate of growth of earnings but this is mainly related to higher City bonuses. When bonuses are ignored, the rate of growth of earnings is less than 4%, still below the 2005 average. Wage settlements, as the MPC has observed, are on average lower this year than last.
While there is no obvious step-up in incomes, the same is not true of inflation. We are all aware that gas and electricity bills have risen almost 30% in the past 12 months and that petrol is close to £1 a litre. This has been joined in the past month or two by higher food prices as the hot weather has pushed up the price of fruit and vegetables. As a result, RPI inflation, which is still a better measure than the CPI of the cost of living for most households, has risen 3.3% in the past year.
There is more to come from gas and electricity and, in all likelihood, petrol. University tuition fees go up for new students in the autumn and this month’s base-rate rise will feed through to mortgage interest payments in September. The cost of servicing the debt on mortgages, which is already at 12% if repayment of principal is included, will rise even further. Putting this all together, we expect RPI inflation to pick up to just under 4% in the coming months. On the current trend in wages, pay will not be keeping pace with prices.
Inflation is not the only thing eating into household budgets. As the August Inflation Report recognises, the tax take from households has risen in recent years. Last year alone taxes on income and other items rose 8.3% while social contributions, which include national insurance, were up more than 10%. A telling chart in the MPC’s latest Inflation Report shows that real post-tax labour incomes fell in the first quarter as higher taxes and prices outweighed the rise in nominal incomes.
All this seems to make for a subdued backdrop to consumer spending. But there is some upside. Although unemployment is still rising, this is only because job creation is not keeping pace with the population of working age. Employment has risen by 240,000 (0.8%) in the past year, and labour-market surveys suggest this trend will be maintained in the near term. Nearly half of all mortgages are on fixed rates and will not be affected by the August rate hike. Equally, the housing market, which was a drag on spending in 2005, has returned to life and should not be derailed by this month’s quarter-point rise in rates. And for those with savings, higher interest rates are a plus.
Advertisement
Yet it is hard not to conclude that the downside risks to consumer spending are significant and could come into play once any near-term momentum has run its course. Demand in the economy as a whole may still be supported by business investment and exports, as the MPC is forecasting, but in the event of a serious drop in consumer demand, they will not be able to fill the gap.
The MPC forecasts GDP growth of 2.8% this year and 3.1% next year. For that to happen we need a solid contribution from the consumer. The risk is that we will not get it. And, if we don’t, we will not get the 5% interest rates that the MPC is also assuming will be required to get inflation back to 2% over the medium term. If we rein in our spending in the months ahead, rates can stay at 4.75%. The ball is in our court.
Geoffrey Dicks is the chief UK economist at RBS Global Banking & Markets