The end of the inflation shock

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Afternoon all,

Big news coming on the economic front next week: unless something goes awry inflation should fall to within touching distance of the Bank of England’s 2 per cent target when April’s consumer prices data comes out on Wednesday (the Bank’s own forecast is 2.1 per cent). It’s a big landmark after a long three years, since July 2021, of above target inflation.

All the rows next week will be about the politics (“we’ve turned the corner” vs “stop gaslighting people”) and monetary policy (“when’s the first rate cut?”). So we wanted to have a TOTC special (and new report) digging into what risks being ignored: how Britain has been changed by the biggest inflation shock for four decades.

I hope you find it an interesting read, while you get the deckchairs out this weekend.


Chief Executive
Resolution Foundation

Paciest prices

While the price surge has been seen across the world, the UK’s inflation shock has been the largest in the G7, with eleven years’ worth (22 per cent) of normal (2 per cent) inflation taking place in three.

The high inflation might be done but the impact of those three years of price rises isn’t. And not all price rises have been equal: the relative cost of essentials is up. Wholesale energy costs have thankfully fallen back from their mad summer 2022 levels, but retail energy prices look set to remain over 50 per cent above their March 2021 level by the end of this year. Food prices are up nearly 50 per cent more than overall price level. Why does this matter? Because more expensive essentials make for a more difficult Britain to live in, with less financial space for the fun things in life even as families (especially those on lower-incomes) cut back on essentials. We’re not just spending more on food, we’re eating less of it: food consumption actually fell 4 per cent between Q1 2022 and Q1 2023.

Inconsistent incomes

Wages generally haven’t kept pace with price rises – I’m guessing you’ve noticed. Real wages are down 2.3 per cent since early 2021. But again, big shifts in relative wage levels have taken place. Lower earners have done better than higher earners, thanks to the minimum wage broadly keeping pace with prices. Waiters, chefs, and nursery staff have seen the among the largest hourly wage rises between 2021 and 2023; whereas lawyers, university lecturers, and IT professionals have had some of the largest falls. There’s been a big public/private split too with public-sector workers average weekly earnings falling 5.9 per cent since the start of 2021 vs 1.6 per cent in the private sector (where a tight labour market has had more impact).

But to understand how different groups have done we need to recognise that beyond wages, other elements of families’ income have fared very differently. Against most expectations, the government has protected the real value of benefits in the face of the inflation surge (most recently with a 6.7 per cent uprating in April) – in part because massive cuts in the proceeding years made it impossible to do otherwise. And if benefit income is broadly flat, savings income has surged (up £40 billion, admittedly from very low levels) as interest rates have risen in response to inflation. So, the incomes of older households, receiving an inflation protected state pension and getting some interest on their savings for the first time in years, have fared better than their younger, working compatriots.

Spending surprises

Wage falls dominate the rosier picture for other income sources, so real household disposable income per head is down, even if not by as much as feared (1.1 per cent below its pre-pandemic level by late 2023). This is where things get… surprising. How have households responded to rising prices? The stereotype of the British consumer is they keep consuming regardless, so we’d expect to see them borrowing more and running down savings to get through the cost of living crisis. But the British consumer has changed. In fact, they’ve cut consumption far more (down 4.7 per cent) than their income has fallen. In the face of higher prices they have actually saved £54 billion more (and consumed £54 billion less) in 2023 than if saving had returned to its 2019 rate. This continues behavioural change that has seen Brits borrow less since the financial crisis and save more during the pandemic.

Consumption falls, here and in most European countries, are in stark contrast to a spending binge taking place in the US, where real consumption per head is eight per cent above its pre-pandemic level. Much stronger income growth across the Atlantic (not being reliant on Russian gas made the last few years a lot easier…) explains most of the difference. But US households have also done the opposite of British, French and German families, by saving less (the savings ratio is down two percentage points between late 2019 and mid-2023 in the US, compared to a three percentage point rise in the UK). It’s hard to prove exactly what’s driving the difference, but generally consumers in countries that have had a strong recovery from the pandemic have saved less, and those that have seen weak recoveries (ie Europe) have saved more – possibly reflecting gloomier views about what the future has in store.

Shunning stuff

Households spending less is about us buying less stuff: goods are making up a smaller share of consumption. On food and energy we’re spending more to get less, while cutting real spending on on more durable goods, for example spending on household appliances is down 18 per cent since early 2022. And, while we went out less in the peak of the cost of living crisis, spending on services like eating out and holidays has bounced back as energy bills have retreated. So Nandos is back in, B&Q is still out.

Benign balance sheets?

If people are borrowing less and saving more, does this mean household balance sheets are improving? For some. The winners include those who have seen chunks of their debt inflated away. But those whose mortgage debt is now worth less probably won’t feel perky: those re-mortgaging in 2023 saw their repayments rise by an average of around £2,450 thanks to higher interest rates. And those rates affect asset prices as well as mortgage bills: we estimate £2 trillion has been wiped off the value of interest rate sensitive assets like houses (we’ve seen an eight per cent real house price fall), with older households losing most.

So, it’s a mixed picture for household balance sheets. It’s a much simpler, negative story for the public balance sheet. As inflation kicked in many speculated this would help reduce government the debt burden (by boosting nominal GDP), as we saw in previous high inflation phases. After all, public sector net debt fell during previous inflation shocks: by 11 percentage points of GDP in the 1950s, and 7 percentage points through the 1970s and early 1980s. Not this time though – debt is up 6 percentage points of GDP from 2021-22 to 2023-24. The debt destroying impact of faster inflation has been more than wiped out by the need to spend billions protecting families and firms from high energy bills (£50 billion in 2022-23), plus the UK has been busy issuing inflation-linked debt since the 1980s, so higher inflation has actually increased the size of our debt stock. Looking ahead, higher interest rates more permanently increase costs via higher debt interest bills over the years to come. There’s no public finances silver lining to the impact of the price surge of the past three years.

Contemplate as well as celebrate

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