May 27, 2022

News in Charts: What does the (real) squeeze in incomes mean for policy?

by Fathom Consulting.

Media headlines are awash with stories of a squeeze in the post-tax income that UK households have at their disposal after taking account of inflation.  With inflation expected to rise faster than wages, will this squeeze persist? Will it lead to recession and what should policymakers do about it?

UK inflation is soaring while growth is slowing: the classic hallmarks of a negative supply shock. There are many sources of that shock: distortion of global supply chains during the pandemic, the deadening effect of Brexit on UK trade flows, and higher commodity prices are just some of the culprits. Whether monetary policymakers can or should ‘look through’ the rise in inflation depends on whether there are second-round effects. If there are no second-round effects, the correct response to a negative supply shock is to see through it: the shock will drive prices up and aggregate demand down, but there is no impact on inflation in the medium term. The story changes, however, if there are signs that wages are starting to spiral upwards in response.

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Labour market data are already providing some warning signs. Average weekly earnings including bonuses rose by 9.9% in the twelve months to March — significantly higher than CPI inflation, which was 7% over the same period. Media stories have tended to focus on regular pay excluding bonuses, which rose by a more modest 4.1% — a fall in real terms. But bonus pay may be a better indicator of future trends, as it is more flexible than regular pay, and reacts more quickly to changes in labour market conditions. The difference between total and regular pay is therefore arguably a better picture of underlying pay growth — and smoothing these payments across the preceding twelve months suggests that underlying pay growth in the year to March 2022 was 6.8%. If we exclude the extraordinary conditions of the past two years, that is the highest rate on record. Thus the UK may be in the early stages of a classic wage-price spiral, though for now it would be premature to conclude that we have returned to the levels of persistence experienced in the 1970s.

IN HOUSE

Recent Fathom work has shown the link between rising inflation and deteriorating consumer confidence. It is unsurprising to find that, amid the highest inflation that the UK has experienced in decades, consumer confidence has fallen to levels that would typically signal the start of a recession. This is true regardless of whether individuals are polled on their personal financial situation or their views of the wider economy. Strikingly, confidence in individual financial situations is now at the lowest on record, worse even than during the early days of the pandemic when support schemes may have helped to cushion the blow to incomes.

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The Office for Budget Responsibility (OBR) expects a 2.2% percentage point decline in real disposable income this year and a further small decline next year. Despite this, it does not foresee a recession. Whether this holds true will ultimately depend on whether consumers perceive the fall in their real incomes as temporary, and dip into their pandemic savings, or whether they view it as permanent, and retrench. A great deal hangs on how consumers decide to behave: the outlook for consumer spending in the UK (and elsewhere), and therefore for wage inflation, consumer price inflation and interest rates.

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Higher inflation is driven by numerous factors, most of which could be described as supply shocks. Fathom’s most likely scenario is that many of these will fade over the coming quarters. Unfortunately, the UK already appears to be showing signs of second-round effects from the current burst of above-target inflation, more so than in the US. It is for this reason that Fathom sees a material risk that higher inflation will persist for longer than many in the UK expect. While it is unlikely that inflation will prove as sticky as in the 1970s, inflation persistence does appear to have risen somewhat. As a result, it is unlikely that the Bank of England can rely solely on its credibility to bring inflation back to target, and further rate hikes are likely to be required.

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