When will consumer spending emerge from the doldrums?

What Harold Macmillan once called “events, dear boy, events” have been coming at us thick and fast. Election uncertainty here was followed by prolonged budget uncertainty. And there was that other election across the Atlantic more recently. I doubt if anybody got the outcome they wanted from all three events.
Anyway, I mention them because for many businesses, notably those depending directly on consumers, this is a crucial time. Black Friday is quite a recent phenomenon here — it was not even a thing in the UK when Labour was last in power — but judging by the number of emails whizzing into my inbox, retailers are placing a lot of hopes on it.
They have good reason to do so, particularly at a time when they are warning of dire consequences from the budget’s national insurance hike. Retail sales volumes have picked up a bit in recent months, but they remain below pre-pandemic levels: in September, sales volumes were nearly 2 per cent below where they were in September 2019.
More dramatically, they are 9 per cent below where they stood in April 2021, the end of the last Covid lockdown, when in-store retailing was reopened to what shop owners hoped would be a surge in demand. It never happened.
The cost of living crisis intervened and, as Donald Trump discovered to his benefit last week and the Tories to their cost a few months ago, it does not go away when the inflation rate comes back down to earth. The rate of change in prices may have subsided, but prices are still higher. The National Institute of Economic and Social Research does not expect average living standards to return to pre-2022 levels for another 18 months. People still feel quite squeezed.
It is not just retailing. What the Office for National Statistics describes as consumer-facing services, which include hospitality, are running more than 5 per cent lower than immediately before the pandemic, and have grown by a mere 1.5 per cent, in total, over the past two years.
When it comes to big-ticket items, the latest car registration figures from the Society of Motor Manufacturers and Traders (SMMT) tell the story well. Last month, private new car registrations were down by 11.8 per cent on a year earlier. So far this year, private buyers have been buying 9.6 per cent fewer cars than last year. Some of that reflects a reluctance to switch to electric vehicles, but much of it is consumer caution.
Draw all this together and you have a picture of weakness for household spending. Even as the economy was recovering in the first half of the year, consumers were lagging behind, which was unusual. Spending in the second quarter was no higher than a year earlier.
Why is this happening, and will it go away soon? Conventional wisdom at the time was that consumer spending in the UK was being held back by uncertainty over the general election, followed by uncertainty over the budget. Both are now out of the way and, though only tentatively so far, the Bank of England has started to reduce interest rates from what were 16-year highs.
There is no mystery about what determines the outlook for consumer spending. It depends on the rise in incomes and the proportion of those incomes that are saved.
The Office for Budget Responsibility (OBR), in its budget forecast for the economy, saw the interaction of incomes and savings producing very weak growth in consumer spending this year, just 0.4 per cent. Real household incomes are projected to rise by quite a strong 2.4 per cent, the biggest increase in the OBR’s five-year forecast, but a hike in the saving ratio from 9.7 to 11.5 per cent of disposable incomes snuffs out most of that rise in incomes when it comes to spending.
Things get a bit better next year, according to the OBR, a 2.1 per cent rise in real household incomes converting into a 1.7 per cent increase in consumer spending, because the saving ratio only rises by a small amount, to 11.8 per cent.
After that, weak growth in real incomes might suggest that consumer spending will be very weak, but the OBR sees a fall in the saving ratio to a “normal” 8.1 per cent by 2029, supporting modest growth in spending, averaging 1.75 per cent a year — slower than its average of more than 2 per cent a year in the 2010s, and much slower than in earlier decades.
The budget may be out of the way, and Rachel Reeves went out of her way to avoid new direct tax hikes on most households. But the chancellor’s measures will nevertheless bear down on consumer spending, in large part because higher employers’ national insurance (NI) contributions will mean slower growth in wages and salaries.
“Real private consumption is forecast to fall 0.4 percentage points as a share of GDP [gross domestic product] from 2023 to 2029,” the OBR said. “In our pre-measures forecast, we expected this share to rise by 0.4 percentage points, but this is more than offset by policy measures in the budget … The level of consumption is 1.6 per cent lower at the start of 2029 than in our March forecast [for the Conservative government’s last budget].”
If you are not in one of those consumer-facing businesses, you might say this no bad thing. A common complaint about the UK economy, stretching back many decades, is that we consume too much and save too little.
Unfortunately, according to the latest official assessment, a fall in the spending share of gross domestic product is not matched by a rise in the private investment share, which is also predicted to fall — in this case, by 0.6 percentage points. Exports, which are struggling, were already predicted to grow only weakly — slower than imports — and now face a potential hit from Trump tariffs. The GDP gap is made up by an increase in current and capital spending by the government, which was what the budget was all about.
We come back to a basic point. Stronger growth in consumer spending requires stronger sustained growth in productivity — GDP per hour worked — to generate faster rising real wages. Without stronger private investment alongside the rise in public investment, productivity will continue to struggle.
The OBR sees no growth in productivity at all this year, settling at just over 1 per cent a year thereafter, about half its traditional rate. The official forecaster, it should be said, has been too optimistic about productivity in the past. We have to hope that this time it is too gloomy.
PS
The Bank of England duly cut the official interest rate from 5 to 4.75 per cent on Thursday, in line with expectations. It would have been a surprise, and a recipe for a damaging market response, if it had not done so. Only one member of the Bank’s nine-member monetary policy committee (MPC) voted against the reduction, Catherine Mann, as she did against the previous one in August. It will take something for her to join the cutters.
The MPC majority could easily have not brought rates down, given that the new Bank forecast is for inflation to be above the 2 per cent target for the next couple of years, reaching 2.75 per cent in a year’s time as the energy price falls that have driven its drop disappear from the annual comparison. The budget adds 0.5 percentage points to inflation, according to the Bank, a view it shares with the OBR.
Most members of the MPC decided to “look through” this effect and a short-term boost to growth from higher public spending over the next year, taking the view that inflation will return to the 2 per cent target after a temporary period above it.
The question of how fast and how far rates fall from here has become a live one. The additional cut that many had pencilled in for next month, following dovish comments from Andrew Bailey, the Bank’s governor, is now looking less likely.
As for next year and beyond, the Bank has three different scenarios, or “cases”. In the first, wage and service-sector inflation return to normal quickly as the pandemic and Ukraine shocks unwind. In the second, it will take time for this to happen and require a period of weak economic growth and higher “slack”, or spare capacity, including higher unemployment. Its third case is one in which there has been a permanent shift in price and wage-setting behaviour, which would require interest rates to stay higher for longer.
The Bank’s forecasts are based on the market view that the official interest rate will be 3.7 per cent in a year’s time, implying four cuts next year. But the market view also implies 3.7 per cent at the end of 2026, suggesting not much room for rate cuts beyond next year. Let’s see what actually happens.
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