The End of the Inflation Shock • Resolution Foundation

Afternoon everyone,

Big news comes from the economic front next week: unless something goes wrong, inflation should fall to within a range of the Bank of England’s 2 percent target when April consumer price data comes out on Wednesday (the Bank’s own forecast is 2 .1 percent). It is a major milestone after three long years, since July 2021, of above-target inflation.

All the arguments next week will be about politics (“we’ve turned the corner” versus “stop ripping people off”) and monetary policy (“when is the first rate cut?”). That’s why we wanted a special TOTC (and new report) that looks at the risks of being ignored: how Britain has been changed by the biggest inflation shock in forty years.

I hope you find it interesting to read as you get out the office chairs this weekend.

Torsten

General manager
Resolution Foundation


Paciest prices

Although the price rise is being seen around the world, Britain’s inflation shock is the largest in the G7, with eleven years (22 percent) of normal (2 percent) inflation occurring in three years.

The high inflation may be over, but the impact of those three years of price increases is not. And not all price increases have been equal: the relative costs of essential necessities have risen. Wholesale energy costs have thankfully fallen back from the crazy levels of summer 2022, but it looks like retail energy prices will remain well over 50 percent above March 2021 levels by the end of this year. Food prices have risen almost 50 percent more than the general price level. Why does this matter? Because more expensive essentials make life in Britain harder, with less financial scope for the nice things in life, even as families (particularly those on lower incomes) cut back on essentials. Not only do we spend more on food, we also eat less of it: food consumption even fell by 4 percent between the first quarter of 2022 and the first quarter of 2023.

Inconsistent incomes

Wages have generally not kept pace with price increases. I assume you noticed that. Real wages have fallen by 2.3 percent since the beginning of 2021. But here too, major shifts in relative wage levels have taken place. Lower earners have fared better than higher earners, thanks to the minimum wage broadly keeping pace with prices. Waiters, chefs and daycare workers have seen the largest hourly wage increases between 2021 and 2023; while lawyers, university teachers and IT professionals have seen some of the biggest declines. There is also a major divide between public and private: the average weekly wage of public sector workers has fallen by 5.9 percent since the beginning of 2021, compared to 1.6 percent in the private sector (where a tight labor market has more impact had).

But to understand how different groups have fared, we need to recognize that other elements of household income besides wages have fared very differently. Against most expectations, the government has protected the real value of benefits in the face of the wave of inflation (most recently with a 6.7 percent top-up in April) – partly because the massive cuts in subsequent years made it impossible otherwise to do. And while benefit income is largely flat, savings income has soared (up £40 billion, albeit from very low levels) as interest rates have risen in response to inflation. So the incomes of older households, who receive an inflation-protected state pension and are getting some interest on their savings for the first time in years, have done better than those of their younger, working compatriots.

Issue surprises

For other income sources, wage declines dominate the rosier picture, causing real disposable income per capita to fall, even if not as much as feared (1.1 percent below pre-pandemic levels at the end of 2023). This is where things get… surprising. How have households responded to rising prices? The stereotype of British consumers is that they will continue to consume no matter what, so we would expect them to borrow more and dip into their savings to weather the cost of living crisis. But the British consumer has changed. In fact, they have cut consumption much more (a decline of 4.7 percent) than their income has fallen. Despite higher prices, they will have saved £54 billion more (and consumed £54 billion less) by 2023 than if savings had returned to 2019 levels. This continues the change in behavior that has seen Britons borrow less and spend less since the financial crisis have saved more during the pandemic.

The decline in consumption, here and in most European countries, is in stark contrast to the spending binge in the US, where real consumption per capita is eight percent above pre-pandemic levels. The much stronger income growth on the other side of the Atlantic (not being dependent on Russian gas made the past few years a lot easier…) explains most of the difference. But US households have also done the opposite of British, French and German households, saving less (the savings rate fell by two percentage points in the US between late 2019 and mid-2023, compared to a three percentage point increase in the UK). It’s hard to prove exactly what’s causing the difference, but in general, consumers in countries that have had a strong recovery from the pandemic have saved less, and those that have had a weak recovery (such as Europe) have saved more – which is possible reflects more somber views about what the consequences will be. future has in store.

Avoiding things

If households spend less, this means that we buy less stuff: goods make up a smaller part of consumption. We spend more on food and energy to get less, while cutting back on real spending on more sustainable goods. For example, spending on household appliances has fallen by 18 percent since the beginning of 2022. The cost of living crisis has seen a rebound in spending on services like dining out and vacations as utility bills have fallen. So Nandos is back in, B&Q is still out.

Benign balances?

If people borrow less and save more, does this mean that household balance sheets will improve? For some. The winners include those who have seen parts of their debts blown away. But those whose mortgage debt is worth less now are unlikely to feel cheerful: those who took out a new mortgage in 2023 saw their repayments rise by an average of around £2,450 thanks to higher interest rates. And those interest rates impact both asset prices and mortgage bills: we estimate that £2 trillion has been wiped from the value of interest-rate sensitive assets such as homes (we’ve seen an eight percent fall in real house prices), with older households suffering the most losses . .

So it’s a mixed picture for household balance sheets. For the public balance sheet it is a much simpler, negative story. As inflation took off, many speculated that this would help reduce the government’s debt burden (by increasing nominal GDP), as we have seen in previous phases of high inflation. After all, public sector net debt fell during previous inflation shocks: by 11 percentage points of GDP in the 1950s, and by 7 percentage points in the 1970s and early 1980s. Not this time, however: debt increased by 6 percentage points of GDP between 2021-2022 and 2023-2024. The debt-wrecking impact of faster inflation has been more than offset by the need to spend billions on protecting households and businesses from high energy bills (£50 billion in 2022-2023). Moreover, Britain has been busy issuing inflation-linked debt since the 1980s, so higher inflation has actually increased the size of our debt. Looking ahead, higher interest rates will permanently increase costs through higher interest charges on debt in the coming years. There is no silver lining on public finances for the impact of price increases over the past three years.

Think, but also celebrate

It’s fair enough to celebrate that inflation is returning to target next week – after the biggest inflation shock most of us have ever seen. But politicians may want to be careful about sounding too triumphant if the public is still living with the higher prices. And we should all spend some time understanding how this experience has changed our economy, because we will have to live with the legacy in terms of lower living standards and higher government debt for years to come. Hopefully this whistle stop tour has given you some food for thought.

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