The UK economy is a puzzle. Inflation has burst above 10% for the first time since Argentina was gearing up to invade the Falklands in early 1982. Prices are rising far more quickly than wages. Consumer confidence has plumbed depths not seen during any of the many misfortunes of the past half century.
And yet, the official data shows the British public is carrying on shopping regardless. Retail sales were higher in July than they were in June despite the progressively tighter squeeze on living standards. Airports are busy with holidaymakers, house prices keep on rising. Odd sort of crisis, you might think.
One possibility is that the gloom surrounding the economy has been overdone. Unemployment is low and job vacancies are high. People are not afraid of losing their jobs and if they are laid off they can hope to find another one relatively quickly.
Demand for foreign holidays is strong because many households built up savings during the pandemic when spending opportunities were restricted. Those cash buffers are now being drawn down, bridging the cost of living gap left by rising inflation.
Yes, the Bank of England has raised interest rates at the last six meetings of its monetary policy committee, but in real terms – adjusted for inflation – borrowing costs are still low. Put together all these factors and there is a case for saying the UK will experience a relatively mild downturn this winter.
Even the dire state of consumer confidence can be explained away, because a breakdown of the latest snapshot of sentiment shows people are much gloomier about the state of the economy than they are about their personal finances. The wall-to-wall negative reports about a looming cost of living crisis have been registered but, so far at least, households think they are managing.
It is curious, to say the least, that confidence as measured by GfK is reported to be lower than it was during the three-day week of early 1974, the deep manufacturing recession of the early 1980s and the period in 2008 when it looked as if the banking system would collapse. That may reflect the ubiquitous nature of modern media, and particularly social media, rather than objective economic conditions.
That is the upbeat view. There is an alternative, with consumers in denial about the horrors to come and having a last splurge of spending before they tighten their belts during autumn’s perfect storm.
The gloomy view of the economy goes something like this. Growth has pretty much ground to a standstill in the first six months of 2022, with output rising a bit in the first quarter and falling marginally in the second quarter. The labor market has reached a turning point: employment growth is stalling and the number of job vacancies is coming down.
For now, this is a relatively slow process and many businesses are able to pay more than they would like to attract and retain staff. For the moment, they feel they can pass on the cost of higher wages to their customers by raising prices. The pickup in retail sales growth will do little to discourage them from doing so. This will feed through into core inflation – the cost of living excluding food, fuel, alcohol and tobacco – which is closely watched by the Bank of England and which rose above 6% last month.
A double-digit inflation rate and signs that consumer demand is holding up make it more likely that the Bank will raise rates by 0.5 percentage points next month, after a similar increase in August.
This will add to the financial squeeze on consumers and businesses just as higher domestic fuel prices bite. October’s increase in the energy price cap will push up the annual inflation rate still further, intensifying the squeeze on real incomes and massively adding to the fixed costs for millions of businesses.
There has been plenty of attention paid to what the successor to Boris Johnson will do to alleviate the pain about to be inflicted on households, but less focus on what they ought to be doing to help businesses. In the short term, restaurants, hotels and high street shops will try to pass on their higher costs but they will be less able to do so as consumer demand weakens in the autumn than they have been in the summer. Many will throw in the towel.
Industrial unrest will provide another dimension. Figures from the Office for National Statistics last week showed total annual pay growth in the private sector running at 5.9% and 1.8% for the public sector.
With inflation running at 10.1%, that represents a cut in living standards of more than 4% in the private sector and more than 8% in the much more heavily unionised public sector. Inevitably, there will be more strikes as workers – who can justifiably say they are not responsible for the cost of living crisis – seek to prevent themselves from getting even poorer.
The Bank of England leans towards the gloomier of these two scenarios, which is why it is forecasting a protracted recession for the UK in which unemployment rises by more than a million. Threadneedle Street thinks the good news (such as strong retail sales) is unlikely to persist, and that looks like a reasonable call.
While that won’t stop the Bank from continuing to raise interest rates in the short-term, by this time next year the monetary policy committee will be under pressure to cut them. The economy might appear to be strong. The labor market may seem to be defying gravity. But it is really just a mirage. Consumers are right to be downbeat even if they don’t yet quite appreciate what is coming.