BNY Mellon

Mind The UK Consumption Gap

On the face of things, the latest UK labour market data likely provides the Bank of England with some relief. Nominal incomes are still growing at a relatively firm pace, and there is every chance that much like may be the case for the European Central Bank, the BoE's next set of forecasts may begin to move away from the extremes of previous months.

In the August monetary policy report, we believe the BoE ‘kitchen-sinked’ forecasts based on the most bearish possible assumptions for households; real incomes would see record declines and, as the UK economy remains strongly consumption-driven, the growth drag was a given. Meanwhile, households had all but run down the savings buffer generated during the pandemic so any marginal shock to their cash flow – which was likely to come via higher energy and housing-related costs – would likely cause consumption to decline in real terms. On the other hand, some form of household support was all but certain, and the scale of the weakness in the outlook meant that the bar for upside surprises would not be high.

So far, the BoE has been correct in its assessment of the household reaction function. Nominal incomes are robust but expectations and real income declines matter for consumption. As the chart below shows, on an annualised basis, real incomes have been on the decline for eight months in a row, while annualised core retail sales volumes are also declining. There is a strong base effect component from the Q2 2021 post-vaccination reopening phase and the data remains noisy. Nonetheless, considering how strongly demand has recovered this year in various services segments while restrictions were still tighter through much of 2021, the data are disappointing. GDP is positive again on a sequential basis but there is a case of lost potential output due to current price pressures.

As the government has signalled a freeze in energy bills from October, households will find some breathing space in cashflow. The BoE will likely take this into account. Using an 8% inflation rate to proxy for nominal median household income growth from 2021, a £2500 energy price cap would equate to restricting energy as a share of expenditure to just above 7%. This is still above the 4.8% average for FY 2021 but comfortably below the 10% threshold commonly defined as 'energy poverty'. As consensus expectations for inflation due to the support program are already falling, there is some scope to expect a shorter contraction in real incomes, and therefore upside risks to consumption and real growth compared to prior assessments. The support may need to come at the expense of incomes through taxation or other levies, but that will remain beyond the current forecast horizon.