The cost-of-living squeeze - what is it, and why is it happening, and how bad could it be?

There’s lots in the press about households facing a ‘cost-of-living squeeze’. But what does it actually mean? I wanted to take a bit of time to go through what it is, why it’s happening, and evaluate how bad things might get. 

Before I get started, a few acknowledgements to people who have shaped my understanding of this topic. My father and grandfather were both government statisticians. My grandfather had two main senior roles in the latter part of his career –  in one he led statistics at the Department of Health, in the other he was responsible for stats at the Price Commission, responsible for measuring inflation. Later on he spent some time in Africa helping a country that was experiencing hyper-inflation. I wish I could ask him his views about recent events in our lives – if only he were around now, this blog might have fewer questions and some more precise answers!

However, I’m lucky that my wife has an economics degree and her brother is an expert on energy (check out https://twitter.com/ukenergywonk), so you can guess where our conversation tends to go when we get together. And I should also credit my co-founders who are also well-read on these topics.

The first thing to say about ‘the cost-of-living squeeze’ is, it’s not just inflation. Rising prices are just one part of the squeeze – the other part is about pay and tax changes reducing household’s disposable income. But let’s start with rising prices. 

There are a number of factors at play and some are intertwined. In other words, this gets complicated. Let’s start with the one that seems to have come first, and has taken up most of the headlines – energy.  Energy is more than 10% of household expenditure for bottom decile households (and over 4% even for top decile households), so it’s significant in and of itself.

I’ve blogged before about why energy prices are going up – a combination of political factors, increased reliance on renewables and a less sunny and windy year last year, etc etc. This is a significant contributor to rising household costs. It looks like the average household will be forking out hundreds of pounds more on their domestic energy bill alone when the price cap rises in the spring, and that whilst the government might do something to smooth the impact, support that doesn’t get clawed back later will be reserved for a relatively small number of households.

Rising energy prices are so significant because they affect many other prices too – as an input to production. If I need energy to make something, and energy bills are going up sharply, it costs me more to produce that thing, which puts on pressure to increase prices.

Then there’s the labour market. The labour market is incredibly complex, but there is clearly a labour shortage in certain industries, which pushes pay up, and hence the cost of goods and services. A current example is the HGV driver market, which can’t correct quickly due to the longer training period. And of course, Brexit seems to have changed the mobility of certain labour groups from the continent to this country as well. 

Covid has also created other pressures. Whilst some groups have been impacted quite heavily by the pandemic’s economic changes, others have been saving for a long period of time (not commuting, not taking holidays), which might give some producers the ability to raise prices as that ‘pent up’ demand is released.

Next, we get to monetary policy. In the last couple of years, the Bank of England has been practising high levels of quantitative easing. QE is a favoured tool when interest rates are low enabling the government to stimulate economic activity if lowering interest rates is impossible. (Negative interest rates actually are possible, but there haven’t been wide experiments with them, so monetary policy chiefs have gone with large rounds of quantitative easing instead. And to be fair, sustained use of QE (printing money, which pulls up the prices of assets) isn’t particularly well understood either, but has been a part of the landscape of the last 10 years or so). But here’s the rub: since the 2008 financial crisis, we’ve had a sustained period of low interest rates, and we’ve ended up with high levels of consumer debt, particularly property debt. It’s hard to believe that the Bank of England could actually raise interest rates significantly without causing the consumer debt bubble to burst (even if those rises are comparatively small, they still result in higher mortgage costs, which reduce disposable income and mean some people can’t keep up and are forced to cut other costs or worse still, lose their homes) sending us into a crisis and probably a deep recession. 

The market, knowing all this, has a collective expectation of inflation, which causes inflation as prices rise in anticipation of rising input costs and so forth. 

And then we get to the last piece in the puzzle: the rise in National Insurance. The government needs to raise cash (it has spent a lot during the pandemic to prevent the economy shutting down – furlough, loans, test and trace, etc. – and it was running a deficit even before Covid. The NI rise will offset some of that, but it will reduce net pay and increase costs to companies, and thus prices. It contributes to the cost pressures for employers by making it more expensive to employ people (employer contributions are going up), but more importantly it will take money out of people’s pockets, because employees will be paying more in tax and suffering a reduction in their take-home pay. 

(Sidenote: I understand that there are lots of ideological debates about what the right level of taxation should be, but this particular move seems like a strange decision, which is why politicians from various different perspectives are currently arguing that this is wrong, or at least the wrong timing).

So, that’s a brisk walk through most of what’s going on. The host of problems we’re facing in the UK are concerning. And cost-of-living rises aren’t just forcing people to cut back on discretionary spending, they’re already making some people have to choose between heating and eating (and both of those essential household bills are set to rise at some pace this year, as pointed out by Jack Monroe recently).

But what does it all mean, and how bad could it really get?

Inflation hasn’t been above 5% since the early 90s. That period (when inflation peaked in the high single digits) coincided with a significant recession. However this level of inflation isn’t a particularly significant change to how the economy normally ‘works’. 

I was talking to my father-in-law about inflation in the 1970s (in the mid-70s inflation peaked at around 25%) and it sounded like a different world. Pay rises would happen multiple times a year (otherwise you just weren’t keeping pace) and people would just leave roles in order to ‘re-set’. There was a huge erosion of the value of savings in that situation, which is one of the major issues with long periods of high inflation, which disproportionately hits those who hold a more significant percentage of their wealth in cash – generally, those who are not wealthy. The flipside was an increase in nominal asset values and reduction in the absolute value of debt, e.g. houses, which is one reason why the baby boomer generation did so well on their primary residences. We often forget that they lived through more challenging economic times at the starting line prior to the last 30 years-worth of low interest rates and asset value rises. In the 70s, pay rises often lagged price rises, tax rates were high, as were interest rates, which put pressure on those servicing debt and balancing household budgets, particularly when recessions caused unemployment.

And if that sounds worrying, there’s Weimar Germany, where monthly inflation reached over 300%. This was caused by the government printing money to pay reparations for WW1, denominated in foreign currency, the demand for which decreased the value of the German currency, which caused prices to rise, which caused people to spend their money rather than save it, which further exacerbated the problem due to increased demand… terrifying. 

If they had raised interest rates they would have had bankruptcies and recession – and possibly revolution – and on the other side they risked ending up defaulting on their foreign debt. In the end they basically got both. Now, those conditions were unusual, but whilst it’s hard to find an economist who thinks we are heading for anything close to Weimar Germany any time soon, some economists do warn of the risk of getting some lesser version of this – unable to shut down inflation with interest rate rises due to the risk of popping the debt bubble and causing bankruptcies, the cycle spirals somewhat out of control with price rises driving wage increases driving price rises, driving short term spending, and so forth.

Whichever scenario you look at, it feels hard to believe that we aren’t heading for a consumer slowdown.The government can’t afford to stimulate with low taxes or high spending over the long term. Central banks have to raise interest rates to keep inflation under control, but can’t pop the bubble by raising them too much. Households will face increased costs while take-home pay gets further taxed to keep the government afloat, and won’t keep pace with rising costs. 

It remains to be seen whether there is a tightrope walk that means we avoid runaway inflation or immediately high interest rates.. For now, households need to be aware that they need to tighten their belts and get clued up about what could be coming..