Is this as good as it gets for households? - Capital Economics
UK Economics

Is this as good as it gets for households?

UK Economics Focus
Written by Ruth Gregory

The strength in consumer spending has been crucial to the economy’s resilience over the past year but there are three reasons why many people think that the consumer sector is living on borrowed time – namely an unfavourable outlook for incomes, low levels of saving and the onset of rising interest rates. We suspect these concerns could prove overdone.

  • The strength in consumer spending has been crucial to the economy’s resilience over the past year but there are three reasons why many people think that the consumer sector is living on borrowed time – namely an unfavourable outlook for incomes, low levels of saving and the onset of rising interest rates. We suspect these concerns could prove overdone.
  • While the recent strength in jobs growth seems to be fizzling out, consumer spending should receive more support in 2019 and beyond from wage growth. Admittedly, our expectation in our “repeated Brexit delay” scenario that inflation will rise further above its 2% target in 2020 means that consumers’ real earnings might edge down a little. But real wages should still grow at a faster pace than over the last few years.
  • Our expectation in a no deal Brexit scenario that inflation rises to just over 3% next year is a bit of a worry. But the big difference between now and 2011, when inflation last rose sharply, is that wage growth is currently much higher. So even if inflation were to rise, this would not necessarily lead to another bout of falling real earnings – as was the case in the five years after the financial crisis and more recently in 2017.
  • Meanwhile, valuable support to consumers’ incomes could yet come in another form – namely a big fiscal boost. The tax cuts promised by Boris Johnson, for example, could boost household incomes by almost 1.5%. That would offset the rise in inflation that we anticipate in a no deal Brexit.
  • The bigger risk to the consumer outlook is that households’ ramp up their savings to more “normal” levels, perhaps triggered by a big rise in interest rates or concerns about Brexit.
  • However, while a rise in the saving ratio is certainly possible, a return to the rates seen prior to the financial crisis is not as inevitable as some appear to assume. For a start, the headline saving ratio can be a bit misleading. Pension contributions are counted as saving, but most households have to wait years before they have access to this income. Stripping out these pension contributions, the saving ratio is far closer to its long-run average than the headline measure. Meanwhile, the shift to a low-unemployment, low interest-rate environment suggests that there are reasons why saving should be lower now than in the past.
  • Finally, there are reasons to think that consumers should be able to take gradual interest rate rises in their stride. Despite the high level of debt, debt servicing costs are at all-time lows. And even if interest rates increase to 1.25% by the end of 2021, as we expect in our “repeated Brexit delays” scenario, debt servicing costs wouldn’t rise by much.
  • As a result, we wouldn’t write off the consumer sector just yet. We doubt consumer spending growth will accelerate from here. But equally we don’t think that higher savings or rising interest rates will result in a significant slowdown. And a big fiscal boost under a new Conservative PM could mean that income growth surprises on the upside. This underpins our view in all our Brexit scenarios that households will remain the strongest part of the economy. In our “repeated Brexit delay” scenario, for example, we expect consumer spending to grow by 1.8% over the next few years, broadly in line with 2018’s rate.

Is this as good as it gets for households?

This Focus is an adapted version of a presentation given at the Capital Economics UK Forecast Forum held in London in July 2019.

In recent years, growth in consumer spending has been one of the few bright spots for the economy. But can this last, especially if interest rates and inflation rise?

This Focus will look at three potential factors that could soon start to work against the consumer sector. First, will a rise in inflation and a weakening labour market overwhelm any boost from a new PM’s tax cuts, bringing the recent improvement in household incomes to an end? Second, will a rise in savings hit consumer spending? And third, can households cope with higher interest rates?

Starting with the sector’s recent performance, Chart 1 shows that consumer spending has not been immune to Brexit. Having grown at rates of about 3% a year ahead of the EU referendum, spending growth slowed in 2017 to about half that pace. But consumer spending growth did not completely collapse as some had expected, either.

Chart 1: Real Household Spending

Source: Refinitiv

Nonetheless, there are a few reasons why many people think that the consumer sector is now living on borrowed time – not least concerns about a weakening labour market, low levels of saving and the onset of rising interest rates.

Picking out the OECD’s latest forecasts for example, consumer spending is forecast to rise by just 0.8% in 2020, less than half of growth in 2018 and just a quarter of the 3.2% rate seen in 2016. (See Chart 2.) If everything else remained the same, that would result in a slowing in economic growth from 1.4% last year to just 0.8% in 2020.

Chart 2: Forecasts for Household Spending (% y/y)

Sources: Refinitiv, OECD, Capital Economics

The prospects for consumers’ income growth

However, there are reasons why we think that these concerns are overdone. Starting with households’ incomes first, this has been the main factor behind the recent resilience in consumer spending growth. After falling in late-2016, real incomes have subsequently risen by just over 2% in 2018. (See Chart 3.)

Chart 3: Real Household Incomes & Spending (% y/y)

Sources: Refinitiv, Capital Economics

Breaking this down into the two major components of real household incomes – employment and real wages – it is clear that employment growth has been by far and away the biggest driver of real income growth over the past five years. (See Chart 4.)

But there have been recent signs that the previous strength in jobs growth is fading, raising concerns that consumer spending growth may soon slow too. Indeed, as Chart 4 shows we think that the contribution from employment will roughly halve in 2020, as the pool of available workers dries up.

Chart 4: Contributions to % y/y real Household Income (ppts)

Sources: Refinitiv, Capital Economics

But we think that consumer spending will receive rather more support in 2019 and beyond from wage growth instead. The headline measure of earnings growth excluding bonuses, has already reached a decade high of around 3.5%.

And with recruitment difficulties at their highest in almost twenty years according to the Bank of England Agents’ survey measure, the recent strength in wage growth should be sustained. (See Chart 5.) Admittedly, the relationship is not cast iron. But there seems little evidence to suggest wage growth will slow.

Chart 5: Average Earnings & Recruitment Difficulties

Sources: Refinitiv, BoE

Of course, a look at the prospects for consumers’ incomes would not be complete without considering what will happen to inflation. Our expectation in our “repeated Brexit delay” scenario (see UK Economics Update “Pick your own Brexit forecast” 1st July) that inflation will rise above its 2% target in 2020 means that consumers’ real earnings might edge down a little. (See Chart 6.) But real wages should still grow at a faster pace than over the last few years.

Admittedly, in our no deal Brexit scenario we expect inflation to rise to just over 3% next year. That is a bit of a worry. But the big difference between now and 2011, when inflation last rose sharply is that wage growth is currently much higher. So even if inflation were to rise, this would not necessarily lead to another bout of falling real earnings – as was the case in the five years after the financial crisis and more recently in 2017. (See Chart 6 again.)

Chart 6: Real Earnings (3m avg. of % y/y)

Sources: Refinitiv, Capital Economics

Meanwhile, valuable support to consumers’ incomes could yet come in another form – namely a big fiscal boost. Jeremy Hunt hasn’t yet made many promises that would directly affect consumers, so for the sake of argument, we are assuming here that the fiscal boost under a Conservative Government might be similar to the tax cuts promised by Boris Johnson.

When you add up such measures, they could boost household incomes by almost 1.5%. That would offset the rise in inflation that we anticipate in a no deal Brexit. (See Chart 7.)

Of course, it might be a different story under a Corbyn Government, given Labour’s pledge to fund increases in day-to-day spending on things like the NHS and schools by raising taxes. The various Labour measures that would have a direct effect on consumers – including reversing a number of tax giveaways and income tax rises, amount to a 1% or so drag on household incomes. (See Chart 7 again.)

Admittedly, Labour’s planned rise in the minimum wage would provide offsetting support to wages. Even so, there is a risk that firms might just pay for higher labour costs by reducing non-wage benefits or employment. And with corporate tax rates and labour costs likely to rise under a Corbyn Government, it is easy to envisage weaker corporate investment which would lead to lower productivity growth than otherwise, and lower real wage growth eventually.

Chart 7: Effect of Fiscal Promises
(% of Households’ Income)

Sources: Capital Economics, IFS, Labour Manifesto

Is an adjustment in savings still to come?

Of course, income growth is not the whole story. The second reason why some forecasters do not expect recent rates of consumer spending growth to be sustained relates to the fact that households are now saving a very low share of their income.

Indeed, a comparison of the household saving ratio – which expresses saving as a share of income – with its long-run average, shows just how little households have been saving of late. (See Chart 8.)

Chart 8: Household Saving
(As a % of Disposable Income)

Sources: Refinitiv, Capital Economics

This could present a major blow to our hopes that solid real incomes will support steady consumer spending growth over the next two years. Indeed, Chart 9 provides an illustration of just how important the saving ratio is for consumer spending. If the saving ratio remained broadly steady at its current rate of around 4%, real consumer spending growth would remain little changed on 2018’s 1.8% rate.

But if the saving ratio were to rise to say 6%, real consumer spending would probably grow at just 1% or so, knocking a chunky 0.6 percentage points off GDP relative to 2018.

Finally, if the saving ratio were to rise back up to its long-run average of 8% then consumer spending growth would all but grind to a halt, knocking over a percentage point off GDP, even if as we are assuming here, that the adjustment is spread over two years.

Chart 9: Real Household Spending (% y/y)

Sources: Refinitiv, Capital Economics

Perhaps the far bigger risk to the consumer outlook than what happens to incomes, then, is that households’ ramp up their savings to more “normal” levels, perhaps triggered by a big rise in interest rates or concerns about Brexit.

However, while a rise in the saving ratio is certainly possible, it is not as inevitable as some appear to assume. For a start, the headline saving ratio can be a bit misleading. After all, pension contribution are counted as saving. But most households have to wait years before they have access to this income. Stripping these pension contributions out, the saving ratio is far closer to its long-run average than the headline measure. (See Chart 10.)

Chart 10: Household Saving*
(As a % of Disposable Income)

Sources: Refinitiv, Capital Economics

What’s more, there are reasons to think that savings should be lower now than in the past due to changes in the macroeconomic environment over the last decade. For a start, even if a Brexit deal is agreed, we think that historically-low interest rates are here to stay, incentivising consumers to spend now rather than save.

Meanwhile, the shift towards a low-unemployment environment in the past decade have provided employees with a greater measure of job security. (See Chart 11.) So households now have less incentive to build up their precautionary levels of saving for a rainy day.

Chart 11: Unemployment Rate
& Household Saving Ratio

Sources: Refinitiv, Capital Economics

The strengthening in net housing wealth appears to have reduced the need for traditional forms of saving recently too, as households can use capital gains as an additional source of income. (See Chart 12.)

Chart 12: Net Housing Wealth & Saving
(As a % of Disposable Income)

Sources: Refinitiv, Capital Economics

Admittedly, a sharp slowdown in the housing market could prompt consumers to ramp up their savings. Equity prices could soon become less supportive in the near term too. But if we are right in thinking that house price inflation will stabilise and start to gradually pick up again, a big upward adjustment in the saving ratio doesn’t seem likely. Given all this, the risk of a sharp rise in savings doesn’t look too high to us at the moment.

Will consumers cope with higher interest rates?

Finally, there is still a risk that given the current historically-high levels of household debt relative to income, even small increases in interest rates could have much bigger adverse effects on borrowers than might have been the case in previous tightening cycles. Indeed, at around 140%, the household debt ratio remains historically high. (See Chart 13.)

Chart 13: Household Debt & Interest Repayments
(As a % of Income)

Sources: Refinitiv, Capital Economics

That said, there are reasons to think that consumers should be able to take gradual interest rate rises in their stride. The cost of servicing debt looks low by historical standards, thanks to the extremely low levels of interest rates. (See Chart 14.)

Chart 14: Debt Servicing Costs (As a % of Income)

Sources: Refinitiv, Capital Economics

Based on our “repeated Brexit delays” scenario in which interest rates increase to 1.25% by the end of 2021, interest and capital repayments as a percentage of households’ total disposable income would probably only rise from 13.4% now to just shy of 15% by the end of that year. (See Chart 14 again.)

Of course, this would change if interest rates increased significantly. But they would have to rise a long way to push servicing costs back up to the 20% income peak seen in 2008, when Bank Rate was almost 6%. Even if rates were to rise by 50bp per quarter to 5.75% by the end of 2021 – Chart 14 shows that they would still only reach 17%.

So debt servicing costs seem unlikely to become a problem on aggregate. And using the Bank of England’s rule of thumb, if Bank Rate were to rise from 0.75% to 1.25% by the end of 2021, as we expect in our “repeated Brexit delays” scenario that should shave only a tiny 0.1 per cent off consumer spending.

Conclusion

Bringing this altogether, Chart 15 shows how each of the four variables discussed in this Focus; the Government’s tax programme, inflation, the saving ratio and interest rates could affect the spending outlook. It is the saving outlook that has the potential to deal the biggest blow to consumer spending over the next few years, dwarfing the adverse effects on spending of higher inflation and interest rates. Indeed, if the saving ratio were to return to its long-run average, it would knock about 2.5ppts off consumer spending.

Chart 15: Possible Effect on Household Spending (ppts)

Source: Capital Economics

Still, we do not think that this risk of rising savings will crystallise. After all, the shift to a low-unemployment, low interest-rate environment suggests that saving should be lower now than in the past. And consumer spending might even gain a little momentum thanks to a substantial boost to spending from the new Conservative PM’s tax cutting agenda. This underpins our view in our “repeated Brexit delay” scenario that consumer spending will continue to grow by 1.8% over the next few years, in line with 2018’s rate. (See Chart 16.)

Chart 16: Real Household Spending

Sources: Refinitiv, Capital Economics

To conclude, we wouldn’t write off the consumer sector just yet. We doubt that higher savings or rising interest rates will derail consumer spending. And a big fiscal boost under a new Conservative PM could mean that income growth yet surprises on the upside.


Ruth Gregory, Senior UK Economist, +44 20 7811 3913, ruth.gregory@capitaleconomics.com