Living standards The Living Standards Outlook 2022 8 March 2022 Adam Corlett Lalitha Try This is our fourth Living Standards Outlook, exploring how household incomes and inequalities may change over the next five years, based on the latest economic forecasts and Government policy. We explore how Covid-19 has buffeted incomes over the last two years; what exceptionally high inflation, the conflict in Ukraine and policy changes will mean for UK living standards this year; and the longer-term prospects for recovery. Our projections use Bank of England and Office for Budget Responsibility forecasts for prices, wages, employment and more, but our modelling looks beyond averages to show what these aggregate forecasts could mean for real living standards across society. Note: Readers may also be interested in our post Spring Statement income projections, which incorporate the new policies and OBR forecasts set out on 23 March 2022. Explore the report: Read the report’s Executive Summary below, or download a PDF of the full report. Executive Summary The UK’s post-Covid economic recovery is well underway, but a deep living standards downturn is just getting going. Two years after the Covid-19 pandemic began, our economy has bounced back from the immediate hit, with GDP returning to 2019 levels and unemployment historically low. But the defining economic feature of 2022 will be a major living standards hit for households, driven by high and rising inflation. The exact path that prices and earnings growth will take is highly uncertain, but it is clear that the war in Ukraine and the further increase in prices that it is already driving will deepen the major living standards squeeze households face. Looking further ahead, it is weak productivity growth rather than high inflation that poses a lasting threat to household living standards. Productivity and pay growth will have to perform considerably better than all forecasts currently expect if the years ahead are to deliver meaningful growth in living standards. This report assesses the prospects for household incomes and living standards up to 2026-27. Our approach is to take the latest detailed data on household incomes (covering 2019-20) and cast this forward using a selection of timelier data (for 2020-21 and 2021-22) as well as forecasts from the Bank of England and Office for Budget Responsibility (OBR), and known tax and benefit policies. Those forecasts pre-date the conflict in Ukraine, so we also look at what effect even higher inflation than previously expected might have on household incomes in 2022-23. High inflation will squeeze incomes in 2022 Higher prices will squeeze household incomes hard over the next year. The main drivers of high and rising inflation are the wholesale prices of gas and oil, which increased rapidly following the re-opening of the global economy, and have increased sharply again since Russia invaded Ukraine. Having stood at 0.7 per cent in January 2021, inflation is currently at its highest rate in 30 years (5.5 per cent), and was projected (before Russia invaded Ukraine) to hit 7.3 per cent in April 2022. The crisis in Ukraine has increased both the scale of price rises, but also the degree of uncertainty about their levels and duration. So far, the conflict has substantially increased the price of oil and natural gas: Brent crude has hit highs of over $110 a barrel, the price of oil futures has also risen commensurately, and the price of gas has exceeded £3.75 per therm (this is the National Balancing Point front-month prices). Considering the impact on petrol and energy costs alone leads us to estimate the monthly peak of inflation will now exceed 8 per cent this spring, and could rival the 8.4 per cent reached in 1991 (in turn the highest inflation since 1982). We now assume that prices in 2022-23 will on average be 7.6 per cent higher than in 2021-22, up from the Bank of England’s forecast of 6.2 per cent in February. This ignores any possible impact on food prices which, if it did occur, would be particularly skewed towards low-income households. High inflation will make falling real household incomes the defining economic feature of 2022. Although rising inflation has so far hit the budgets of richer and poorer households in broadly the same way, that is not necessarily the case as household energy bills surge in April – given that the poorest households spend over three times the proportion of their total expenditure on energy bills as richer households. Higher inflation is also harder for poorer households to deal with, as they have less flexibility in their budgets to cope with higher prices on essentials, and fewer savings to fall back on when prices are high. Increases in the energy price cap mean a typical energy bill will go up by £693, or 54 per cent, in April 2022, after a £139 rise in October 2021. The Government has responded with a £150 Council Tax rebate for those in Bands A to D (with Scotland and Wales introducing similar policies) and a £200 temporary rebate on all electricity bills this autumn. This policy package means a £350 boost to most households’ incomes in 2022-23, but this turns into a £40 drag from 2023-24 as the Energy Bills Rebate is clawed back over the following five years. And the pressure from rising energy prices on household incomes is far from over: the energy price cap was expected to rise again in October even before the conflict in Ukraine began. Based on the latest figures, October 2022 could see a further rise of around 47 per cent – equivalent to around £900 a year for a typical household. Real earnings are now falling, as pay growth fails to keep pace with rising inflation The labour market recovery has been stronger than expected over the past year. One of the great success stories of the Government’s economic policy response to the pandemic was the fact that unemployment remained so low. It peaked at 5.2 per cent in Q4 of 2020, and the latest data (for Q4 of 2021) shows unemployment at 4.1 per cent, only fractionally higher than the pre-pandemic level. This tight labour market means that nominal wage growth is better than would be typical at this stage in an economic recovery, standing at 4.3 per cent in Q4 of 2021. But this remains well below inflation: real wages fell by 0.6 per cent in Q4 of 2021. Despite a healthy forecast for nominal earnings growth in 2022-23, further increases in inflation mean real earnings are set to fall even further in the coming year: by almost 4 per cent using our most recent inflation assumptions. Even on the basis of the Bank of England’s pre-Ukraine inflation forecast, real earnings are not expected to see any year-on-year growth until Summer 2024. We can be confident that real earnings will be falling in 2022-23, but the scale of the hit is highly uncertain. Projecting the near-term outlook for nominal pay is much more difficult than normal: the latest Pay As You Earn earnings growth data (from January 2022) was very strong, at 6.3 per cent, and Bank of England agents were reporting high pressure on pay, but there has been no big take off in advertised wages or settlements, and the latest figures for Average Weekly Earnings show only robust, but far from run-away, pay growth (at 4.3 per cent). Although high inflation will drive the short-term living standards hit, in the medium term it is weak productivity growth that is behind the Bank and OBR’s expectation that ‘normal’ earnings growth by the middle of this decade will still be below the levels we were used to before the financial crisis. The path to reaching those ‘normal’ nominal growth rates of 3.6 per cent in 2026-27 is rocky, with nominal earnings growth projected to fall to just 2.3 per cent in 2024-25. This sharp slowdown is partly due to an expected fall in the labour share (which had risen in the pandemic), and also the rise in employer National Insurance pushing up non-wage labour costs. Fundamentally, wages will not grow strongly unless matched by productivity growth, and here the UK is in a poor position, with the decade to 2019 delivering the weakest growth in productivity in 120 years. An additional headwind to living standards at the moment is that employment has fallen despite an almost total recovery in the unemployment rate, because of falls in labour force participation. Having briefly reached a peak of 64.4 per cent immediately pre-pandemic, the participation rate has fallen during the pandemic, to reach 63.1 per cent in March 2021: a larger fall than previous recessions. The fall in participation among 18-24-year-olds and 50-64-year-olds has been almost twice the average fall. This is particularly worrying for older workers, many of whom say this change is due to ill-health: evidence suggests that such individuals are unlikely to return to the labour market. But there have also been falls among younger men and in the number of migrants working in the UK. Benefit uprating in April will not keep up with price rises The UK’s procedures for uprating benefits mean a rollercoaster ride for benefit rates over the next 14 months, and this will lead to a real, damaging but avoidable living standards rollercoaster for poorer households. Most income-related benefits are uprated in April by the previous September’s CPI. This means that most benefits, including the State Pension, are set to be uprated by 3.1 per cent in April 2022 at a time when the cost of living could be rising by more than 8 per cent. Over 2022-23 as a whole, the value of most benefits may fall by 4.2 per cent in real terms. This is equivalent to a one-off £10 billion cut to benefit spending in 2022-23 – more than the amount the Government spent on pandemic-related temporary benefit increases in 2020-21 – and will take the core level of support in the benefit system to its lowest level in real-terms since 1983-84. The real cut in the value of benefits in 2022-23 is set to be largely undone in April 2023, when benefits could rise by 7 per cent or more. This would be the largest permanent nominal increase for most benefits since 1991-92, when benefits were uprated by 10.8 per cent. This benefits rollercoaster should end up with the real value of most benefits in April 2023 being broadly where they were in April 2021. But that is of little comfort in the meantime to low and middle income households facing a prolonged period where benefits fail to keep up with sharp rises in the costs of essentials. For those on Tax Credits, and most on UC, this comes after the £20 a week cut to their benefits that happened last October, when the temporary pandemic support ended. And some parts of the benefits system are not increased at all in cash terms, most notably Local Housing Allowance. As a result, those who rent privately and receive support for housing costs through UC or the legacy benefits will see no additional support for rents in 2022-23 or beyond, regardless of how quickly these rise. The benefit cap also remains frozen, meaning that families deemed by the benefit system to have the greatest needs will see no additional help in 2o22-23 at a time when the cost of living is soaring. Scheduled tax rises and increasing housing costs will further squeeze disposable incomes April is due to see significant increases in taxes, as the Government combines a fiscal consolidation with longer-term plans to increase spending on health and care. National Insurance rates will rise, while higher inflation means the freeze in Income Tax thresholds will represent a bigger tax rise than originally planned. Although the overall squeeze on living standards in 2022-23 will be felt across the income distribution, and rising energy bills will particularly affect those on lower incomes, the effect of these tax changes will be progressive. For example, households in the second-highest income vingtile will lose 1.8 per cent of their disposable incomes, compared to 0.4 per cent for households in the second-poorest vingtile. Housing costs are also set to rise materially, but on different timescales for different tenures. High inflation will feed through into higher rents in the social sector swiftly. Social rents can currently be uprated in England by a maximum of the previous September’s CPI inflation plus 1 per cent every year, meaning rent rises of up to 4.1 per cent in April 2022, and perhaps over 8 per cent in April 2023. And although some of the poorest households are protected from these large rises through Housing Benefit or Universal Credit, 44 per cent of social renters do not receive housing support. Fluctuating interest rates have fed into sharp changes in mortgage interest payments. A low Bank Rate of 0.1 per cent at the start of the Covid-19 crisis resulted in a fall in average mortgage interest payments of 7 per cent in 2020-21. However, higher inflation than expected has led the Bank of England, and markets, to reassess the future path of interest rates. Two rises in recent months have taken the Bank Rate to 0.5 per cent in February 2022. Although expectations of further rises are falling back somewhat following the Ukraine crisis, we use the market expectation from February, which anticipated rate rises that peaked at 1.3 per cent in Q1 of 2023. Real incomes will take a huge hit in 2022-23, and potentially fall again in 2023-24 Putting all of these factors together, we can model and project changes in household disposable incomes. Focusing on median living standards – and excluding pensioners – our modelling suggests that household incomes were relatively protected in 2020-21 (with growth of perhaps 1 per cent, despite a large fall in GDP) and grew again in 2021-22 (by another 1 per cent). In contrast, despite forecasts for robust GDP growth in 2022 (with the IMF forecasting 4.7 per cent growth), there is an incomes recession ahead of us. Inflation of 7.6 per cent in 2022-23 would leave the typical real household income for non-pensioners 4 per cent – or £1,000 – lower than in 2021-22. This is a scale of fall only previously seen around the recessions of the financial crisis, early 1980s and mid-1970s. Even if we assume no significant lasting fallout from the situation in Ukraine, real incomes are also projected to fall in 2023-24 – with typical incomes dropping by 2 per cent due to falling real wages (in the Bank’s forecast), rising mortgage costs and the abrupt change from a £350 energy support package in 2022-23 to a £40 levy in 2023-24. Falls in typical real income for two successive years have never been experienced outside of recessions. Sadly, the forecast beyond 2023-24 is not encouraging either, with no rapid rebound from the period of high inflation. Projections based on the Bank’s forecasts of weak nominal earnings growth and rising unemployment imply negligible growth (0 per cent) in 2024-25 and 2025-26 and only weak (but welcome) growth of 1 per cent in 2026-27. Given the uncertainty of all income forecasts, but perhaps particularly of the path of inflation and wages over the next few years, we also explore what difference would be made by alternative assumptions. A scenario where nominal earnings growth remained at 4 per cent a year after 2022-23 (rather than dropping as in the Bank and OBR’s last forecasts) and where unemployment remained near its current rate (rather than rising) would improve prospects, but growth in typical incomes in 2023-24 would still be negative. Even with these less pessimistic labour market outcomes – and assuming (unrealistically) that there is no long-run impact of the war in Ukraine on UK living standards –the typical real income would still be lower in 2025-26 than in 2021-22. These trends are far from uniform across the income distribution, however. The incomes of the poorest were boosted in 2020-21 by the temporary boost to UC and Tax Credits – but the removal of these boosts, alongside rising inflation, led to falling incomes for lower-income households in 2021-22. Incomes in 2022-23 are projected to fall right across the income distribution, but the impact of the benefit rollercoaster means that the poorest may see a smaller income fall than better-off households in 2023-24. While we should always bear in mind the very big picture – that real household incomes are generally at or near record highs – it is clear that the current outlook would be an awful result in terms of growth if it were realised. While 2020-21 and 2021-22 were terrible years in many respects, in terms of real household incomes, they are as good as it gets over our projection period up to 2026-27. Comparing four or five-year periods corresponding to Westminster parliaments, we find that 2019-20 to 2024-25 is currently on track to be the worst on record for income growth – even assuming there is no long-run impact of the war in Ukraine on living standards – with the typical non-pensioner income falling 2 per cent, compared with a 1 per cent drop between 2005-06 and 2010-11. Coming on the back of the financial crisis and post-referendum inflation spike, such poor growth in this parliament would leave the twenty-year period from 2005-06 to 2025-26 with an enormous growth shortfall: if incomes had grown in line with the previous long-term trend, the typical income in 2025-26 would be 43 per cent (£11,000) higher than currently projected. A drop in poverty in 2020-21 has probably already been undone As has been shown before, the significant package of increased benefit support in 2020-21 did not just contribute towards protecting household incomes while GDP plummeted, it also drove welcome reductions in income inequality, relative poverty and absolute poverty (assessing the whole population, including pensioners). However, our nowcasting suggests that these changes were essentially all reversed in 2021-22 (despite the permanent UC boost for working families from December 2021). Most strikingly, we project absolute poverty to have fallen from 18 per cent in 2019-20 to 16 per cent in 2020-21 (official figures are due out later in March), but we then project a rise to 17 per cent in 2021-22 and to 18 per cent in 2022-23. Remarkably – but in keeping with the general income outlook – the prevalence of absolute child poverty is projected to be higher in 2026-27 than in 2019-20, with a very large rise of 5 percentage points expected between 2020-21 and 2022-23, in part due to the impact of the war in Ukraine on the cost of living in 2022-23. Beyond the dip and rebound of 2020-21 and 2021-22, the outlook for relative poverty and relative inequality is comparatively flat – as income growth is projected to be weak for everyone. High benefit uprating in 2023-24 may provide a temporary narrowing of inequalities, though relative poverty after that point is set to continue its pre-pandemic upwards trend, as the two-child limit and abolition of the family element continue to affect more families, and as earnings grow more swiftly relative to social security benefits. Relative poverty is projected to particularly rise for households with more than two children. In 2012-13, around one-in-three children in large families (households with three or more children) were in relative poverty. By 2021-22 that may have reached a record high of almost 50 per cent – and by the end of our projection period (2026-27) the majority of children in large families may be living in relative poverty. These forecasts are not set in stone, and the Government could cushion this year’s living standards hit for poorer households Economic forecasts can and will change. It is possible that nominal pay growth will outperform the current weak forecast, or that volatile fossil fuel prices will deliver very low inflation at some point. On the other hand, the economic forecasts we have built upon pre-date the conflict in Ukraine, which, as well as putting pressure on energy prices, may well slow growth. In the long-run, the sustainable route to rising living standards is through a strong economy with faster underlying growth in productivity. How the country’s economic strategy might increase the chances of that happening amidst a decade of significant economic change is the focus of the Resolution Foundation and the Centre for Economic Performance’s Economy 2030 Inquiry. But there are also steps that the UK Government should take to help cushion the significant living standards blow facing households over the next couple of years. Most importantly, the Chancellor should revisit this year’s benefit uprating in or before the Spring Statement. Because each financial year’s benefit uprating is based on inflation from the previous September, even the October 2021 energy price cap rise will not be reflected in benefit rates until April 2023. Although uprating policy does mean that core benefits maintain their real value in the long-run, the benefits rollercoaster that we described above is set to cut £10 billion in real terms from benefit income in 2022-23. This will pose real financial challenges for low- and middle-income households. The Government should therefore increase benefits by more this year, and less next year. For as many benefits as administratively possible, but at least UC and Tax Credits, uprating this April should not be 3.1 per cent but 8.1 per cent. Those benefits that are harder to change at short notice should be increased as soon as possible, and at the very latest in October when the energy price cap is now almost certain to rise again. Benefit increases in April 2023 would then be reduced accordingly. This would not be a permanent change to benefit rates (or public spending), but would significantly protect real incomes for poorer households in the difficult year ahead. In the medium-term, the Government should move permanently to a timelier basis (e.g. December inflation figures) for uprating benefits, or even consider uprating benefits twice a year when price rises are particularly large, to reduce the impact that volatile inflation has on benefit recipients. Second, although the Government has acted to partially cushion households from rising energy bills, there is more that could be done. As well as being more ambitious on insulating the country’s homes, some levies could be moved off electricity bills and instead be funded by general taxation. One specific option would be for the Government to shoulder Renewables Obligation costs (which are legacy contractual obligations), taking around £70 a year off household bills, and transferring the cost of around £2 billion a year from bills and into public spending. Third, the Government must revisit its default policy that Local Housing Allowances are now permanently frozen – regardless of increasing rents; and adjust the benefit cap, which is also frozen. There are many policies that could be suggested to improve the UK’s inadequate benefit provision – and 2020-21 shows again that policy can make a big difference to poverty rates – but a good place to start would be to stop making further real-terms cuts. The UK’s economy may have recovered from the pandemic more quickly than expected – in part because policy makers protected household incomes from its worst affects. But those same household incomes are now entering a deep recession of their own – made worse by the terrible developments unfolding in Ukraine. The rising cost of living will be the defining economic feature of the year ahead. The government’s task against that difficult backdrop is to combine a long-term focus on raising productivity and pay, with immediate action to ease the pain for low and middle income households.