Plugging the gap

Have lower rates helped to plug the income/expenditure gap?

The latest Economic Review from the ONS provides the usual useful compilation of recent economic outputs, reinforcing the sense of momentum underpinning recovery, but questioning just how balanced this new growth is.
One of the most important imbalances it picks up is between consumption and investment. Although still some way short of its pre-crisis peak, the proportion of gross final expenditure (the sum of final uses of goods and services produced by, or imported to, the UK) accounted for by household expenditure has increased from an average of 46.2 per cent in 2011 to 46.9 per cent in Q1 2013. In contrast, the proportion accounted for by spending on investment has fallen from an average of 13.5 per cent in 2007 to just 10.9 per cent in Q2 2013: the lowest level recorded since the 1950s and comparing with a G7 average of 14.6 per cent.

More worryingly still, this increase in household expenditure is somewhat at odds with income growth: in the period since Q3 2011 household spending has increased by 3 per cent, while disposable incomes have risen by just 1.8 per cent. The gap is reflected in a reduction in the household saving ratio (from an average of 6.8 per cent in 2012 to an average of 5.2 per cent in the first half of this year) and the ONS concludes that households have run down their savings (and increased their debts) in order to maintain spending in the face of slower income growth.

This apparent move from savings towards increased debt may seem a little surprising given the still fresh memories of the difficulties caused by credit expansion in the pre-crisis era. Yet it might look a little more rational when we consider that net financial balance (the difference between financial assets and liabilities) remains high by historical standards. It is also likely to have been driven to some extent by significant reductions in the interest rates charged on personal loans since the end of 2012. The report also speculates about the impact of steadily rising house prices on consumer confidence – while noting that the most marked increases have been concentrated in London and the South East.

Nevertheless, with millions of families still dangerously exposed to debts built up in the pre-crisis era, the prospect of a recovery built once again on the backs of borrowers is a troubling one. And we can speculate about another potential – and potentially concerning – explanation for the divergence between spending and incomes: namely that homeowners – particularly  those on lower and modest incomes – are taking advantage of falls in interest rates on their mortgages to offset the wider squeeze on their incomes. That is, while cost of living pressures are bearing down on household budgets, the reduction in the cost of borrowing is helping to plug the gap between incomes and spending. There’s no way of knowing for sure if this is the case, but it would help to explain why the fall in borrowing costs hasn’t produced any significant increase in mortgage repayments.

Why might this be a problem? Because as we all know interest rates are going to rise again,  the only question being when. And, while the governor of the Bank of England has made it clear that he believes this to be some way off – with the new forward guidance ruling out any increase until unemployment falls below 7 per cent – there is a very real risk that the incomes of many of the low and middle income households exposed to a large debt-overhang will not recover significantly until sometime after the increase occurs. Faced with the prospect of increased repayments, such households are likely to have very little room for manoeuvre. At the very least, this could push significant numbers closer to the edge: depending on just how many are in this position, it could even be enough to take some of the steam out of economic recovery.

It’s early days for the recovery, and much of this data is notoriously volatile, but today’s imbalances should sound a note of caution for those celebrating an end to the downturn.

Matthew Whittaker is senior economist at the Resolution Foundation.