Can UK households weather a cost of living squeeze?

Summary

• A widely anticipated rise in Ofgem’s energy price cap should push CPI Inflation to a peak of 6.0% or higher in April
• Living standards have already taken a hit and, due to further rises in inflation, real wages are likely to fall for much of this year
• On the flip side, there are some support mechanisms that may help some households weather a cost of living squeeze – notably, strong growth in the labour market and a chunk of excess savings built up during the pandemic
• But there are signs that lower income households’ financial positions saw more a bigger hit over the pandemic, leaving them much more vulnerable to a cost of living crunch

Inflation is set to rise further…

CPI inflation is one of the broadest measures of the cost of living, covering the average price of a “typical” basket of goods and services purchased by the UK consumer (including utility bills, which will capture past and future rises in Ofgem’s energy price cap). Inflation has been rising consistently over the past year, hitting 5.4% in December 2021 – the highest since 1992.

While a number of expectational factors have played a role in pushing prices higher (see our earlier note for more detail), it’s clear that the rise in inflation has broadened over the past year. The proportion of items in the CPI basket where prices have grown at a rate above 2% year-on-year (i.e. the Bank of England’s target for total CPI inflation) has risen from just under 30% at the end of 2020 to over three-quarters (78%) in December 2021.

Our latest forecast expects CPI inflation to rise further in the months ahead, and to stay elevated over the coming year. Taking into account outturn data and global oil price movements since our forecast, we can expect a peak in CPI inflation of around 6.0% or higher in April 2022 (when Ofgem are widely expected to raise the energy price cap again).

…and real wages will fall for much of this year

The direct impact of higher inflation on households’ purchasing power is tricky to gauge at present. This is because ONS data on average earnings is artificially inflated by base and compositional effects from 2020/early 2021, which pushed wages lower this time last year.

Nonetheless, taking the data at face value, real wages are now falling year-on-year, for the first time since mid-2020. A similar picture emerges when we look at a range of other data on pay growth, from surveys to pay settlements (which will be less affected by the same methodological issues as the ONS data). These are also running well below CPI inflation, suggesting that heavier declines in real pay lie ahead.

Indeed, our latest forecast expects real wages to fall for much of 2022, as inflation persistently outpaces wage growth. This comes at a time when households will be facing several other constraints on take-home pay:

• Rise in National Insurance Contributions in April 2022
• The freeze in income tax thresholds from 2022/23 onwards
• Squeeze on benefits, which will be uprated by a smaller percentage (3.1% - the CPI rate in September 2021) than the current rate of inflation (5.4%)

Households have some financial buffers against a cost of living squeeze…

While the real wage squeeze will bite hard, there are more positive underpins to households’ finances, which may help them to weather a rise in the cost of living:

• Growth in employment has been strong and shows little sign of slowing. In particular, the labour market doesn’t seem to have seen a significant hit after the end of the Job Retention Scheme. The one thing to watch here will be whether the impact of the Omicron variant on activity will feed through to the labour market in the months ahead
• In aggregate, households have accrued a large amount of excess savings over the course of the pandemic: on one measure (looking at changes in households’ bank deposits), these total around £193 billion. This should provide a financial buffer to weather a cost of living squeeze ahead

…but lower income households are much more vulnerable

However, it’s likely that these areas of support will benefit some households more than others. In particular, survey data from the Bank of England suggests that the vast tranche of excess savings has been concentrated among higher and medium-income households, as well as retirees. In contrast, lower income households and the unemployed have had to run down savings on balance to fund day-to-day spending.

Therefore, those consumers whose financial positions were negatively impacted by the pandemic are likely to be rendered even more vulnerable by a cost of living squeeze. Higher inflation will also hit lower income households harder, due to differences in consumption patterns. Analysis by the Institute of Fiscal Studies shows that households in the lowest income decile spend almost three times as much of their budgets on gas and electricity as the highest-income tenth. Therefore, inflation in April (which is set to be driven higher by another rise in the energy price cap) will be on average 1.5 percentage points higher for the lowest-income tenth of households than the highest-income tenth.

As a result, although households in aggregate are likely to have some financial buffers against a rise in the cost of living, it’s clear that some groups will feel the pain more than others.