A lack of credibility is a disaster for policy-makers. Credibility is so important because most economic decisions, such as household spending or firm investments, involve making plans about the future. This also applies to decisions about price setting, such as wages demanded and paid, and prices charged by firms.

Macroeconomic policy can help with this planning if it promotes a stable economic and financial environment and convinces people that the economy will evolve in predictable ways. In that sense, macroeconomic policy is concerned with managing the expectations of different groups of people or organisations in the economy.

Fiscal credibility

When a government like the UK’s is making decisions about fiscal policy – measures related to public spending and taxation – it can finance itself more easily and more cheaply when it is credible. This is because the UK, like most countries, maintains a large stock of government debt and regularly runs deficits by spending more than it collects in tax revenue.

There is nothing wrong or unusual about this. But it does mean that the government needs to borrow money regularly. And like any borrower, prospective lenders want to be sure that they will get repaid.

Governments are not like households or firms – there is a greater expectation that the country will still be around to pay back any borrowing. They also have the power to tax to be able to make their repayments.

But governments do sometimes default on their debts and the greater the chance of this happening, the less enthusiastically lenders will make funds available. Of course, they can offer to pay back higher interest rates, and this will make it worthwhile for lenders to take the risk.

But higher interest rates mean that a greater share of government spending goes on interest payments rather than providing useful public goods and services, or reducing taxes.

The role of credibility has been particularly important in macroeconomics for around 50 years. And a key part of maintaining credibility is how institutions are set up.

For example, these days, the central bank – the Bank of England in the case of the UK – is typically independent from politicians. This allows it to make tough decisions, even at uncomfortable times, to ensure it gets as close as possible to achieving its objectives of low and stable inflation (and financial stability).

More recently, governments have subjected their fiscal plans to scrutiny by independent experts – the Office for Budget Responsibility (OBR) in the UK – while still, rightly, leaving the specific policy choices to elected officials.

This is why budgets can be costly if they are not set against a clear and credible plan to finance any new spending (or tax cuts). Even if that financing will take place over many years or even decades, the presence of a clear plan can reassure potential lenders that the policies are well thought out and sound. Transparency of plans and endorsement by an independent fiscal council provide reassurance to the markets and the public.

This is part of what made the UK’s recent ‘mini budget’ such a disaster. By declaring it as a 'non-budget', the new Chancellor rendered it outside the remit of the OBR, which would usually provide independent macroeconomic forecasts for any budget, as well as properly costing proposed policies. Immediately, lenders became suspicious and nervous.

Combined with other events, such as the recent removal from office of the most senior Treasury civil servant and repeated talk that the government was thinking about reviewing the mandate of the Bank of England, alarm bells started to ring. Loans to the UK government, because they now appeared riskier, would need to pay a higher interest rate.

Monetary policy credibility

It is not just governments that need to be concerned about credibility. Central banks equally must worry about their reputation. Academic economists don’t necessarily always agree with one other; and neither do academics and policy-makers on all issues. But one thing on which there is reasonably strong agreement is the need for monetary policy to be credible.

Central banks can more easily hit their inflation target if everyone believes that inflation will turn out to be at the target level. This is because when they make financial and economic decisions, they do so with the expectation that prices will increase by something close to the target.

So, when firms decide how much to charge for their goods or services, when workers determine what wage to ask for, or when banks choose what interest rate to charge on a loan, they base it on expecting the target rate. In doing so, they then contribute to everyone facing prices consistent with the target. It is self-reinforcing.

Alan Blinder, an American economist and former central banker at the US Federal Reserve, once wrote that ‘A central bank is credible if people believe it will do what it says’ (Blinder, 2000). But credibility is not a given: it is earned.

Indeed, the Federal Reserve’s policy-making body (called the Federal Open Market Committee, FOMC) – arguably the most powerful and credible central bank in the world – worries consistently about its inflation-fighting credentials (Cieslak et al, 2022).

Of course, there are times when it makes sense to throw caution to the wind – this is the use of credibility to provide insurance against the worst possible outcomes. But there are other moments when the potential loss of anchored inflation expectations must be taken seriously. Sometimes, the risks of the latter follow from a period when the central bank provided the insurance and prevented a potentially much-worse downturn.

The case for higher interest rates

In recent months, some commentators have argued that the Bank of England raising interest rates is counterproductive. Why, the argument goes, should the central bank raise interest rates and compound the misery of high inflation for people by increasing their mortgage repayments and the costs of debt repayment for firms? There are two answers.

The first concerns the exchange rate. When central banks raise rates, this tends to strengthen the exchange rate. A stronger (more appreciated) exchange rate means that goods priced in foreign currency become relatively cheaper: for example, oil and gas, paid for in dollars, become cheaper in terms of sterling. The opposite happens when rates are lowered.

Importantly, it is the relative movement of interest rates versus other central banks that can cause this. Even if the Bank of England raises interest rates by 50 basis points (bps or hundredths of 1%), this can seem too little when other central banks are raising by 75 bps, as the Fed has done several times recently. The ensuing depreciation of sterling introduces even greater inflationary pressure into the economy.

The second answer is credibility. This is not always intuitive. It relies on realising that the official central bank policy interest rates are only one driver of the rates that households, firms and the government itself are facing.

Like any investor, a lender worries about the return – the annual income they will receive from the borrower for use of the loaned amount. While most lending contracts are expressed in money terms (the nominal value), what really matters is the return after adjusting for inflation (the real value) because this determines the purchasing power of the return.

Lenders wanting to receive a 2% real return will have to add the inflation that they expect over the life of the loan. Lenders also worry that the future may turn out differently to how they expect. When they worry that inflation might be more volatile in the future, they increase the required return to compensate for this, in the same way that they increase the required interest rate when a borrower looks less likely to be able to repay in the future.

The central bank has two linked influences on these beliefs. The first is their framework, which, in the UK, sets the objective of the Monetary Policy Committee (MPC): to achieve a specific low and stable value of inflation (the inflation target).

The second is that the central bank takes policy actions that influence, not directly set, the real return that lenders require and hence the rates at which lenders in the economy provide loans. And the lenders must think of the amount that they will need to get over the life of the loan. This can, in the case of mortgages, be 25 years or more. Lenders need to think about what actions the central bank will take in the future.

The central bank must take policy actions to ensure that it maximises the chances that it will hit the inflation target. Sometimes these decisions are difficult ones. A former long-serving Chair of the Federal Reserve, William Martin Chesney Junior, described the central bank as ‘the chaperone who has ordered the punch bowl removed just when the party was really warming up’.

In some circumstances, such as those we face today, it is much tougher than that. It feels like central banks are taking away the water and paracetamol when everyone has a hangover. And the hangover wasn’t even because of their own over-indulgence – it feels like their water was spiked with vodka!

In a world where lenders understand that the central bank’s actions will ensure that inflation will be around target in the future, and not too volatile, the lending rate rises just because of the central bank’s action. This is where the central bank has maintained its credibility.

If, on the other hand, the central bank appears to ignore its inflation target and instead to cut rates to try to ease the burden on households, then its credibility is likely to be lost. In this case, lenders might not expect policy rates to go up, but lending rates rise anyway because the weakened commitment to the inflation target means that the lenders charge more for expected higher and more volatile inflation.

In both cases, interest rates faced by households and businesses rise. So, is there a difference between these two scenarios?

In the short run, maybe not – both are painful for households and businesses. But in a world where credibility is maintained, the central bank will at least have retained anchored inflation expectations. This gives it some chance of bringing mortgage rates down when inflation is reduced.

In the world where credibility is lost, the central bank will have to work harder, with higher interest rates for longer, to show that it really is committed to low and stable inflation again.

Central banks want to take decisions that do the least amount of damage. Building up credibility is hard, so working not to lose it can be the best option. This can even be the case if it involves short-run pain (for a discussion of the US experience in the 1970s and 1980s, see Reis, 2021).

But since tough monetary policy risks adverse effects on the economy and the financial sector, the central bank needs to strike a balance between toughness, but not counterproductive destruction. This is why it is much easier to not lose hard-earned credibility.

In those difficult circumstances, fiscal policy – changing taxation or public spending – can be used to safeguard the most vulnerable. What is not helpful is talk of weakening the commitment to low inflation (because interest rates rise).

Similarly, uncosted and unchecked fiscal plans – which cause markets to worry that the government will inflate away the debt (because interest rates rise) – can be damaging.

Further, any policies that raise interest rates increase the risks to financial stability, which make the Bank of England’s job of re-anchoring inflation expectations much harder. The monetary-fiscal mix, even in a world of independent institutions, remains important for macroeconomic outcomes.

Where can I find out more?

• Central-bank credibility: why do we care? How do we build it? Article by Alan Blinder in the American Economic Review.
• Policymakers' uncertainty: Anna Cieslak, Stephen Hansen, Michael McMahon and Song Xiao.
• The Fed pivots: goodbye soft landing – hello disinflation: by Carl Walsh.
• Losing the inflation anchor: Ricardo Reis, Brookings Papers on Economic Activity, 2021

Who are experts on this question?

• Jagjit Chadha
• Richard Davies
• Michael McMahon
• Ricardo Reis
• Silvana Tenreyo

Author: Michael McMahon

Picture by pcruciatti on iStock

The post What can happen when economic policy-makers lose credibility? appeared first on Economics Observatory.

The events of recent weeks have led to comparisons with the 1970s when the country saw nationwide strikes that resulted in millions of lost working days (Office for National Statistics, ONS). But is this an accurate parallel to draw?

Current disputes draw on comparable problems – high prices and stagnant wages – to the strikes in the 1970s and similar groups of workers are involved. False narratives of the 1970s, articulated by current critics of trade unions, distort understanding of the present problems. Unions then and now are wrongly portrayed as greedily advancing selfish pay claims that cause inflation.

The current disputes

The current industrial action mainly involves trade union members employed in delivering public services. They work for councils and publicly owned bodies, for example, in healthcare. Others are in private companies that provide services that are not open to market competition, such as the railways.

These workers operate within the ‘foundational economy’, which is responsible for maintaining the vital infrastructure and operational elements of everyday life. Without their work, the economic and social wheels of the country grind to a halt.

The gender, ethnic and age diversity of these workers varies from some existing stereotypes of strikers as relatively privileged older, white men. This socially diverse profile is reinforced when we consider that most employees in the foundational economy were identified as key workers during the pandemic. The recognition of these jobs has perhaps strengthened expectations of future reward that have not been fulfilled.

The immediate cause of the current disputes is the rising cost of living, particularly related to increasing food and energy prices. The doubling of domestic gas and electricity prices since the start of 2022 was accompanied by an increase in petrol prices of over 25% from January to late June. Further price escalation is almost certain. Inflation in the UK, at 9.1%, is at its highest rate for 40 years. Analysis of household expenditure estimates by the National Institute of Economic and Social Research (NIESR) indicates that household bills now exceed income in 60% of UK homes.

As a result, it can be argued that strikes in pursuit of wage claims are not the drivers of inflation, as some UK government ministers have claimed. But rather that they are a collective response to the broken relationship between employment and economic security.

In-work poverty – defined as when an individual’s income, after housing costs, is less than 60% of the national average – has grown incrementally since the 1980s. In the UK, this already affected one in eight workers before the recent cost of living crisis emerged (Joseph Rowntree Foundation, 2022). The New Labour government tried to alleviate this with tax credits and other wage subsidies after 1997. The Conservative-led coalition government scaled these back radically from 2010, while reducing support for low-income family housing costs.

The Institute for Public Policy Research (IPPR), reporting in May 2021, saw these two factors as driving the general increase of in-work poverty. Double-earner households, one full-time and the other part-time, were twice as likely to be in poverty in 2019/20 (12%) than in 1996/97 (6%) (IPPR, 2021). This is likely to have contributed to the rapid escalation of food bank usage by wage-earning households reported in the press.

Two important structural forces shape this in-work poverty. First, the loss of around four million jobs in manufacturing, metals and mining, which resulted from the anti-inflationary policies adopted by Margaret Thatcher’s Conservative government after its election in 1979.

Second, trade unions were politically marginalised. Thatcher’s governments and their Conservative successors made it progressively easier for employers to ‘derecognise’ unions. Trade union density – the portion of the workforce represented by unions – fell from around 50% in 1979 to around 30% in 1997. In 2021, the figure stood at around 23%, although in the public sector, it remained at around 50% of workers. The strikers in 2022, drawn from this unionised minority, are operating from a position of weakness rather than strength. They have limited alternatives when seeking to have their voices heard. The government’s reluctance to support workers has been further underlined by the apparent abandonment of the Conservative Party’s 2019 commitment to produce an employment bill that would protect workplace rights lost as a result of Brexit.

Disputes in the 1970s

Strike activity measured in working days lost was higher in the UK in the 1970s than in any other decade in the period after the Second World War (Office for National Statistics, ONS). In 1972, the first of two peak years, 23.9 million working days were lost. This was mainly driven by a seven-weeks long national strike of 280,000 coal miners, followed by a further three-weeks long strike in 1974, which contributed to the electoral defeat of Edward Heath’s Conservative government.

This established the narrative of privileged male trade unionists exerting illegitimate political influence through relentless industrial action. Most coal was bound for electricity generation in power stations, so the miners were central protagonists in the UK’s foundational economy of the 1970s.

Strikers in the second half of the decade were likewise mainly drawn from this segment, with national strikes of healthcare and council workers, firefighters, dockers and lorry drivers, among others. Strikes of manufacturing workers tended, by comparison, to be either localised or short-lived.

Foundational economy strikers in the 1970s, as in the 2020s, were diverse in ethnic, gender and generational terms. Union density among women workers rose from 31% in 1970 to 40% in 1980. Workers of African and South Asian heritage were prominent in strike movements in manufacturing industry, notably the famous campaign for union recognition among photo-processing employees at Grunwick in London in 1976-77, and with healthcare, council services and transport, especially during what became known as the winter of discontent of 1978-79.

The winter of discontent dominates political memories of the 1970s. 1979 was the second and largest peak year of days lost to strikes in that decade, at 29.5 million. Only around half of these days, about 15 million, were actually lost in the pay bargaining year of 1978/79. The other half were in the following pay bargaining year of 1979/80 when 31 million days were lost, driven by a national strike in the steel industry. This is an important detail. Many reflections on the winter of discontent consciously or unwittingly double its economic significance by repeating the error that it cost around 30 million lost working days.

Strikes in the 1970s were mainly shaped, as in the 2020s, by economic insecurities that stimulated workforce demands for increased wages. Coal miners in the 1970s were seeking to arrest a declining relative position. In the 1960s, the workforce had been cut by more than half, as the UK accelerated towards a mixed-fuel economy.

The national coal strikes of 1972 and 1974 were prefigured by lengthy and large unofficial work stoppages in 1969 and 1970. The sudden fuel shock of 1973-74, when oil prices quadrupled, strengthened the bargaining position of miners, but also intensified inflationary pressures that were already rising rapidly. The peak rate of inflation approached 25% in 1975, compared with 9.1% today.

It was the Labour government’s attempt to control inflation after 1975 that underpinned many of the strikes that followed. Wage rises were controlled by annual fixed percentage increases. Total cash increases therefore grew more slowly for lower-paid workers. They viewed the downward squeeze on their wages as unjust, especially when set against less restrictive measures on dividends and profits.

The Labour government was, of course, sympathetic to unions. It strengthened statutory provision against workplace inequalities of gender and ethnicity, and established the Health and Safety Executive. It also attempted to transform authority in workplaces with an agenda for industrial democracy. This would have included worker-directors in companies with more than 1,000 employees.

Business opposition blocked this, in league with the Conservative Party and the anti-union national press. Strikes therefore remained the only meaningful expression of workers’ voice in the 1970s, as in the 2020s, a signal of collective weakness rather than strength.

Conclusion

Strikes are expensive expressions of workforce voice and acts of last resort. This discussion of current and historic strikes shows that they tend to be a sign of weakness, arising where workers are not being listened to, as much as they are a sign of strength.

The current strikes are clustered in the unionised parts of the workforce. Those involved are occupationally diverse and of varied ethnic, gender and generational backgrounds. They are mainly providing vital services and can be understood as operating within what is termed the foundational economy.

Critics of these striking workers seek to misrepresent and delegitimise them through mobilising a stereotyped view of the past, focusing on the 1970s, the peak decade of industrial action in post-Second World War Britain.

But the 1970s to which these critics return did not exist much beyond the front pages of anti-trade union newspapers. Then, as now, strikers were diverse in their background, attempting to protect precarious living standards in a period of rising economic insecurity.

Where can I find out more?

• No longer managing: the rise of working poverty and fixing Britain’s broken social settlement: Report by Clare McNeil, Henry Parkes, Kayleigh Garthwaite and Ruth Patrick for the Institute for Public Policy Research.
• Government's solutions don't go far enough:  TUC article by Suha Abdul.
• Mick Lynch media mania – the appeal of workers’ power: article by Ewan Gibbs.

Who are experts on this question?

• Jim Phillips
• Alan Manning
• Alex Bryson

Author: Jim Phillips

Picture by atlantic-kid on iStock

The post Industrial action: is the UK going back to the 1970s? appeared first on Economics Observatory.

The latest Halifax House Price Index (for August 2022) shows that house prices increased by 0.4% from July, while the average rate of monthly house price inflation over the last year has been 0.9%. On the other hand, the average house price rose to a new record high of £294,260 in August – 11.5% higher than August 2021 (though annual house price inflation was slightly lower than July’s rate of 11.8%).

Several factors have kept house prices buoyant. On the demand side, certain groups were able to save a lot during the periods of lockdown, boosting household savings by around £200 billion. In addition, an increase in remote working led to greater demand for larger houses. Previously ultra-easy monetary policy and relaxation of counter-cyclical capital buffers by the Bank of England also contributed to keeping house prices high.

On the supply side, planning restrictions and supply chain bottlenecks over the past year have limited the procurement of key materials for construction. This has had the knock-on effect of keeping the supply of new homes tight and prices elevated (see the previous version of this piece for more details).

How is the cost of living crisis affecting the housing market?

Despite the strength that the housing market has shown against an abysmal economic backdrop, both data and survey evidence suggest that activity is slowing. The continued rises in energy and food bills are reducing demand in the housing market as people feel their budgets are squeezed. This pressure is slowing the growth of UK house prices (see Figures 1 and 2).

Figure 1: Monthly housing transactions and mortgage approvals

Source: Bank of England. Note: the shaded turquoise area shows projected values.

Figure 2: Monthly percentage change in house prices

Source: Bank of England

How might tax changes outlined in the recent ‘mini-budget’ affect housing?

On 23 September 2022, the Chancellor of the Exchequer, Kwasi Kwarteng, introduced a cut in the stamp duty on residential property transactions. (This is similar to the actions of one of his predecessors, Rishi Sunak, during the height of the pandemic in 2020 and 2021.) Kwarteng also doubled the 0% stamp duty threshold for residential properties from £125,000 to £250,000.

In addition, the Chancellor increased the threshold above which first-time buyers start paying stamp duty: from £300,000 to £425,000. The maximum amount that an individual can pay while remaining eligible for first-time buyers’ stamp duty relief was also increased to £625,000.

While this policy reduces transaction costs, and may encourage demand, the danger is that increased demand will translate into higher house prices without helping home ownership grow.

The wider macroeconomic conditions are also important here. The impact of the recent tightening in the Bank rate by a further 50 basis points (to 2.25%), a weaker pound and the potential positive effect of the mini-budget on inflation and short-term interest rates are likely to outweigh the benefits of the stamp duty cut.

What does this mean for mortgages and house prices?

The interest rates on the loans provided by financial institutions (including residential mortgages) are linked closely to the Bank rate. Subsequently, an increase in the Bank rate will translate into higher mortgage rates (although not by the same magnitude).

The increase in debt servicing costs will affect variable and tracker rate mortgage holders, rather than fixed-rate mortgage owners (although buyers applying for a new fixed-rate mortgage or existing fixed-rate mortgage owners who need to refinance will also be affected by higher interest rates on their mortgages).

Mortgage rates have already been rising for new mortgage holders, even before the latest political developments. This was due to a general tightening in monetary policy introduced to try to slow inflation. In the second quarter of 2022, the weighted average interest rate on fixed-rate residential loans and variable-rate loans increased by 0.25 and 0.64 percentage points, respectively, since the last quarter of 2021.

But at the time of writing, they are lower compared with historical mortgage rates (see Figure 3). In August 2022, the Bank of England reported that lending rates for new fixed-rate mortgages rose across all loan-to-value (LTV) ratios by between 8 and 25 basis points, with high LTV mortgage rates returning to peak levels last seen during the height of the pandemic.

Figure 3: Overall weighted average interest rate on mortgages (%)

Source: Financial Conduct Authority

Higher monthly mortgage repayments will reduce people’s disposable income. This is likely to have a negative impact on discretionary consumption, and therefore GDP. Prior to the latest policy changes, the National Institute for Economic and Social Research (NIESR) forecast that real personal disposable incomes would decline by 2.5% in 2022 and 0.8% in 2023.

First-time buyers are likely to be discouraged from applying for a mortgage because of rising debt servicing costs at a time when inflation is already eroding real disposable incomes. This could, in turn, reduce demand for housing and cause house prices to fall.

The stamp duty reform is unlikely to encourage many new house purchases, as prices remain relatively high and the cost of living crisis continues. It should be noted that during the height of the pandemic, when stamp duty was initially cut, it encouraged house purchases because of the change in consumer trends, which bolstered savings, and more significantly, because the UK’s cost of living crisis was yet to emerge.

Will the housing market collapse?

One view is that unless policy-makers set out a clear plan on how to control public sector borrowing and balance the public finances, the Bank of England will need to contain domestic demand and inflation by more aggressive Bank rate hikes. This could then result in a significant decline in house prices and lead to negative spillover effects across the housing market and the wider economy.

An alternative view is that the worrying economic outlook has reduced the risk appetite of lenders. This, in turn, has helped to prevent the build-up of systemic risk and large-scale disruption in the housing market, particularly as house servicing costs rise.

Gross lending secured on dwellings in August 2022 was £3.2 billion lower than in May 2022. The latest data on household credit growth show that for the three months to December 2021, it was 3.2% – five times lower than before the global financial crisis of 2007-09 (see Figure 4).

Figure 4: Household credit growth (%)

Source: Bank of England

Even prior to the recent developments, there has been a reduction in risky mortgage lending since the global financial crisis, which has limited the build-up of financial vulnerabilities. In June 2014, the Bank of England’s Financial Policy Committee introduced more thorough affordability checks on potential mortgages, alongside banks facing limits on the supply of very high loan-to-income mortgages. This set of ‘macroprudential’ policies has helped to manage mortgage lending risks.

Figure 5: Proportion of residential lending to individuals – by type

Source: Financial Conduct Authority

It is also worth noting that fixed-rate mortgages make up the lion’s share of total mortgages in the UK, at around 95% (see Figure 5). These homeowners are already tied into a mortgage product that offers, for example, a fixed rate of interest for either two years or five years.

As of March 2022, around 60% of current fixed-rate mortgages were on five-year contracts. This means that an increase in the interest rate is not going to have an immediate effect on households’ monthly repayments (or cause repercussions to the entire UK housing market) unless these households are refinancing or applying for a new fixed-rate mortgage. Roughly one-third of households are unaffected by interest rate rises as they already own their houses outright.

Another factor that will help to prevent large-scale disruption in the housing market is the greater proportion of double-income households with mortgages (see Figure 6). A household managed by two individuals with two sources of income is likely to be better equipped to cushion themselves against higher living costs.

Figure 6: Residential loans to individuals

Source: Financial Conduct Authority

The prevalence of these types of homeowners will reduce the probability of large-scale defaults even if mortgage rates continue to rise. It is also possible that two employed and financially secure individuals may be more confident when purchasing a house, irrespective of the current climate, further supporting housing demand.

What about the rental market?

Private rental prices in the UK increased by 3.4% in the 12 months to August 2022 (see Figure 7). This was the largest annual growth rate since this series began in January 2016. A double whammy of excess tenant demand and shortage in supply has kept rental rates high.

The latest Royal Institute of Chartered Surveyors (RICS) report for August 2022 suggests that these supply shortages have resulted from changes in regulation and taxes. They also show that rental prices are forecast to increase by 4% on average across the UK, over the next year.

Figure 7: Annual growth in rental prices in the UK

Source: Office for National Statistics

Although changes in monetary policy are not going to affect tenants directly, the worsening cost of living crisis will have more of a direct impact on those renting. Landlords can increase rental rates as economic conditions change – for example, in the wake of higher interest rates.

Consequently, this would reduce demand for rental properties relative to residential properties. And because of rising costs across the board, there are heightened risks that rent arrears may increase, particularly during the winter. This could reduce demand in the rental market.

Conclusions

Unless the UK government lays out a concrete plan for controlling the public finances and helps to reduce financial market turmoil, the Bank of England will need to raise interest rates by more than is currently expected in order to contain excessive inflationary pressures. If rates rise too high, there is a risk that house prices will decline sharply.

That said, given the lower risk appetite of lenders, a larger share of fixed-rate mortgages, a relatively higher proportion of outright owners and a relatively small proportion of mortgages needing refinancing over the next year, higher mortgage rates alone are unlikely to cause significant financial disruption or lead to wide-scale defaults.

The surging cost of living – which is squeezing disposable incomes – together with rising interest rates are more likely to affect those in rental accommodation, those with variable-rate mortgages, those who are first-time buyers or those needing to refinance their mortgages, compared with fixed-term mortgage holders who don’t need to refinance in the short term.

The higher cost of living may even discourage risk-taking by prospective homeowners, particular single applicants, especially if they are forced to run down savings to meet the higher cost of living. This may in turn depress demand for new housing, slowing down price growth, despite the stamp duty incentives.

Where can I find out more?

• UK house prices have not risen as fast as people think and may be about to peak: An evaluation by Douglas McWilliams and Kay Daniel Neufeld suggests that UK house prices will be hard to sustain in the near future. Homebuyers are likely to face the headwinds of higher mortgage rates and squeezed living standards from higher inflation.
• Expected falls in house prices unlikely to make housing more affordable for young buyers: Karl Thompson argues that there are few advantages to be had from lower house prices.
• What lies ahead for property in 2022: Could we see a drop in house prices? Barclays Wealth Management look at different analysts’ opinions on the outlook for the housing market.

Who are experts on this question?

• Barry Naisbitt (NIESR)
• Paul Cheshire (LSE)
• David Miles (Imperial College London)
• Geoff Meen (University of Reading)
• Christine Whitehead (LSE)

Author: Urvish Patel

Editors’ note: This is an update of an Economics Observatory article originally published on 29 June 2022 (previous version available here).

Picture by William87 on iStock

The post Update: What next for the UK housing market? appeared first on Economics Observatory.

This raises a host of questions. What caused the financial market gyrations: was it really a reaction to the ‘mini-budget’ or something wider? Was the Bank right to respond? And what does it mean for the rest of us?

This column tells the story using ten charts running from official data. Most are interactive: you can use the date sliders to zoom in on what’s going on right now or zoom out to see the UK’s long-run history.

The background: prices, policy and debt

To understand the troubles this week, start with the fact that the UK is currently skewered on a fork with three sharp prongs. The first is prices: the extraordinary run-up of inflation over the past six months. Year-on-year prices rose above 10% and are still close to this (Chart 1).

Figure 1: Inflation (CPI, % change over 12 months)

Source: ONS

The Bank of England, which mandated to hit an inflation target of 2% a year, began to raise the interest rate that it controls, aiming to tamp down inflation. Bank Rate has risen from 0.25% in 2021 to 2.25% (Chart 2). This is a large and rapid monetary tightening, something the UK has not seen for decades.

Figure 2: Bank of England interest rates (bank rate, %, 1975-2022)

Source: Bank of England

The Bank’s task, even before this week, was the most difficult it has faced for years. This is the second prong: tricky monetary policy. While the global financial crisis of 2007-09 and its aftermath were devastating in terms of employment and output, monetary policy decisions in the period from 2010 to 2020 were, in a sense, simple. Both output and inflation tended to be too low, both needed to be pushed up, and stimulative policy – low Bank Rate and quantitative easing (QE) – was a way to do this.

The current mix is different. The UK is like a house where one room – the GDP room (Chart 3) – is too cold and another – the inflation room – is too hot. But the radiators in the rooms have no individual controls, and there is just one thermostat. Do you turn it up or down?

Figure 3: GDP growth rate (quarterly, chained volume measure)

Source: ONS (Series: IHYQ)

The third prong is the state of the country’s public finances. The UK’s debt-to-GDP ratio has risen over the past 30 years. Two events – the global financial crisis and the Covid-19 pandemic – explain big changes. But even in calmer times, debt has tended to creep up (Chart 4).

Figure 4: Public sector net debt (% GDP)

Source: ONS (Series: HS6X)

Chancellor Kwasi Kwarteng’s budget last Friday was supposed to be a ‘mini’ one. In it, he set out a range of tax cuts and national insurance reductions, steps that would reduce the country’s tax revenue. This came on top of increased spending on a package to cap energy prices as a way to help households and firms facing higher costs. With income down and spending up, the implication would be more borrowing (Chart 5).

Figure 5: Public sector net borrowing (£ billion), actual and forecast

Sources: ONS, IFS, OBR. Note: The red bars are forecasted figures based on IFS analysis and OBR data

So, the government was due to sell additional new bonds – the IOUs known as gilts by which it funds public spending that exceeds tax revenues. At the same time, the Bank was set to re-sell bonds it had bought as part of QE. The supply of bonds, in other words, would expand. Prices duly fell. This was then reportedly amplified by pension funds, which became forced sellers. With the price of bonds tumbling, their yields – which move inversely to prices and represent the UK’s borrowing costs – shot up (Chart 6).

Figure 6: UK Government borrowing costs (spot curve, nominal)

Source: Bank of England

The UK’s currency – like its bonds – cheapened. A weaker real economy means less profit for firms and makes dividends less likely: this dulls the demand for UK currency to buy stocks and shares. The bond market turmoil meant lower demand for the sterling needed to buy bonds. Supply and demand were working against UK assets, and the currency duly depreciated fast against the dollar (Chart 7).

Figure 7: Sterling-dollar exchange rate (USD into GDP)

Source: Bank of England (Series: XUDULSS)

Was this an overreaction by international markets or a home-grown problem? The answer is a bit of both. It is certainly the case that bond markets more widely have seen some sharp moves, with the yield on the US ten-year bond – a vital global benchmark – creeping up and seeing some large daily moves (Chart 8). Stepping back (use the slider on the chart), it is clear that bond yields have been extraordinarily low for years.

Figure 8: US-UK ten year bonds

Sources: Bank of England, FRED

But some of it is home-made. One quick and dirty way to assess this is to compare the US and UK government yields. This can be thought of as the ‘UK effect’ – stripping out the global trend. Before this summer, the UK paid less on its ten-year IOUs than a comparable US bond. This reversed in August, with a noticeable spike over the past week. Since then, bond buying by the Bank of England has brought yields back down.

Figure 9: Borrowing costs – the UK effect (spread, UK vs US 10y bonds, premium over Germany)

Sources: Bank of England, FRED, Bundesbank

So, what does this mean for the rest of us? The first thing to realise is that, like it or not, we are all bond market investors. Whether through pensions (either private or employers) insurance funds or our banks, the vast majority of us have a claim on government bonds. Losses on these portfolios have long-term effects on our wealth.

More immediately, the hit will be via interest rates, and in particular mortgages. High street banks’ own funding costs tend to move in line with those of the government, and to be passed on to borrowers. Mortgage rates are likely to rise both because of the Bank Rate hike and due to higher bond yields (Chart 10).

Figure 10: UK household interest rates (%, credit cards/mortgages)

Source: Bank of England (Series: IUMCCTL, IUMTLMV)

This one-two punch could deliver a knockout blow, lowering household disposable incomes that have already been chipped away at by higher prices. While the pound may have bounced back, the economic impact will be a slower burn, felt over the coming years.

Author: Richard Davies, Director

Picture by Glyph Studio on iStock

The post What’s happening to the UK economy? appeared first on Economics Observatory.

NHS England defines unpaid carers as those who look after someone who cannot cope without their support due to illness, frailty, disability, a mental health problem or an addiction.

Unpaid caring roles often go beyond personal care – such as help with washing, dressing and eating – and include other essential forms of support. This might involve helping to manage finances, shopping for essentials, mobility assistance, ordering medication and emotional support (Carers Trust, 2021).

Nearly 60% of unpaid carers live in a household where someone is disabled; a similar proportion of unpaid carers are women.

Around 8-10% of the UK’s population provide or receive unpaid care, although estimates differ depending on the definition in survey questions. This share has remained relatively stable for 15 years.

But in absolute terms, demand for care is rising, as the UK’s population is getting older and the prevalence of working age disability has increased. In 2019/20, 1.9 million requests for social care support were made in England, over 5% more than in 2015/16.

Care costs have risen, demand has increased, and local authority funding for social care in real terms was only 0.4% higher in 2019/20 than it was in 2010/11. These trends are likely to continue, so we might expect the number of unpaid caregivers and recipients to increase.

The support needs of those who receive unpaid care, and the commitment made by those that provide it, can often strain family finances. Recent analysis finds that people in these households are less likely to be in employment and more likely to fall below the poverty line compared with the rest of the population.

This means that, on average, households where an individual provides or receives unpaid care came into the cost of living crisis with less financial resilience to the pressure being placed on household budgets.

But even within this group, the impact of high inflation will not be uniform. Those receiving care come from a range of socio-economic backgrounds and have different requirements in terms of their care.

What is missed by headline inflation figures?

While prices are rising across the economy, it is primarily energy and transport costs that are pushing up inflation. These costs are rising faster than any other type of goods or services. The consumer prices index including owner-occupiers' housing costs (CPIH) rose by 8.8% in the year to July 2022, and 40% of this rate was driven by transport, electricity, gas and other fuels.

This means that households that spend a greater share of their income on energy and transport will be at the sharp end of the cost of living crisis. Evidence tells us that this will include many households where someone provides or receives unpaid care.

We know that disability often has a direct impact on energy usage, with many care recipients needing to consume more energy at home because of their impairment or condition. This comes on top of other cost burdens that can fall on individuals with support needs, such as specialist equipment or adaptations to the home.

Unpaid carers themselves also face an additional burden on household finances. For example, they may incur higher transport costs due to providing care.

This means that, in general, the composition of these households’ spending will leave them facing a higher rate of inflation than the headline figure suggests. But the extent to which this is the case will depend on individual circumstances.

What about work?

Some people might respond to the rising cost of living by taking on extra hours to increase their earnings. There is ample opportunity for this. The number of job vacancies in the UK economy is over 60% higher than it was in the months preceding the Covid-19 pandemic.

But households where unpaid care is a factor are limited in their ability to work. This applies to both carers and care recipients. A key barrier is the time spent providing or receiving care. Evidence indicates that the higher the care commitment, the greater the impact on earnings.

For example, a study by the New Policy Institute finds that the poverty rate for unpaid carers rises significantly where more than 20 hours of care are provided per week (35% for 20-49 hours per week; 38% for over 50 hours per week; compared with 14% for 0-4 hours per week).

There are many other barriers to employment for care recipients. These depend on their health condition, but they can include inaccessible workplaces, a lack of support or reasonable adjustments from employers, and bias in the hiring process.

These barriers are evident in labour market outcomes. The latest data show a disability employment gap in the UK of 28%. For carers, the employment gap is 10%. In the UK; more carers exit the workforce than elsewhere in Europe; and those who do are unlikely to return.

An important factor is not just access to the labour market in general, but also limits on the type of jobs available. Support needs can often be unpredictable, meaning that unpaid carers and care recipients require flexible working arrangements, which are not available in every workplace.

The impact of unpaid care on labour market access is less pronounced for those above working age. Pensioners’ incomes are more secure, as private and state pensions tend to be the main source of income for these households. This explains why unpaid care does not lead to higher poverty rates in pensioner households. The effect of the cost of living crisis is therefore likely to be similar to the pensioner population in general.

What role can policy play?

Limited access to the labour market can leave unpaid carers and care recipients more reliant on income from social security (national insurance in the UK), especially where the hours of care provided are high.

An important factor here is whether the unpaid carer and the care recipient live together. This is for two reasons. First, support needs in these households tend to be higher, which restricts the ability to work. One study finds that when unpaid care exceeds 20 hours per week, three-quarters of carers live with the care recipient. Second, these households lose two incomes: those of the unpaid carer and the care recipient.

Any decisions taken on social security in response to the cost of living crisis will therefore be significant to these households.

What benefits are available for unpaid carers and care recipients?

Unpaid carers on low incomes might be eligible for means-tested benefits, such as universal credit. The carer’s allowance is also available to some, although this offers relatively little protection (only £67.50 per week). Income from the state pension is deducted from carer’s allowance. In Scotland, an additional supplement of £491.40 per year is available.

Unpaid carers who provide fewer than 35 hours of care per week or earn more than £132 per week after tax and national insurance cannot claim carer’s allowance.

Those who receive unpaid care might be eligible for the personal independence payment (PIP), or one of the older benefits that this has replaced. Eligibility depends on how support needs affect a person’s daily living and mobility. Payments range from £61.85 to £156.90 per week and are intended to account for the additional living costs associated with disability.

For low-income households, universal credit has a ‘limited capability for work related activity’ element, which provides up to £354.28 per month. There is also a ‘carer’s element’ of up to £168.81 per month.

The attendance allowance and pension credit are the equivalent benefits for pensioners who need help or supervision with personal care or living safely in their home.

What has happened to these benefits during the cost of living crisis?

Benefits are usually increased in line with the consumer price index (CPI) inflation level from the previous September. This means that in April 2022, benefits were uprated by 3.1%. Inflation has since reached 10.1%.

This means that the impact of the cost of living crisis is a significant real-terms cut to the value of financial support provided to many households where unpaid care is a factor. This is especially acute for those with higher support needs and where the carer and care recipient live together.

In response, the government announced a series of flat-rate payments to benefit recipients in May 2022. They have offered £650 for means-tested benefits, £150 for non-means tested disability benefits and £300 for pensioners who claim the winter fuel allowance.

These measures will offset 93% of the energy price rise for the poorest households, which might overlap with some unpaid carers and care recipients.

But no specific consideration has been made for unpaid carers’ vulnerability to rising energy and transport costs. Indeed, the carer’s allowance is not a qualifying benefit for any additional support in response to the cost of living crisis.

What about mental health and wellbeing?

Unpaid care often results in a deterioration of health outcomes for carers. One study finds that unpaid carers who provide high levels of care are more than twice as likely to suffer from poor health than non-carers.

Other research finds a strong relationship between mental ill health and the intensity of a carer’s commitment.

Public health protections during the pandemic saw the withdrawal of many care packages and the closure of support services, such as day centres for people with learning disabilities. This resulted in unpaid carers’ roles intensifying, leading to exhaustion and burnout among many. The added burden of stress that is associated with deteriorating household finances is of particular concern for this group during the cost of living crisis.

What further evidence do we need?

The cost of living crisis has been prominent in the news this year, partly because economic statistics around inflation and pay are published regularly. These statistics are disaggregated. This means we can see, for example, the inflation rate for particular types of goods or how wages are changing for men and women.

Economic surveys that ask specifically if a member of a household provides unpaid care are published less regularly. In particular, the annual Family Resources Survey tells us a lot about household finances and includes questions on unpaid care.

When more up-to-date versions of these surveys are published, we will know more detail about how the cost of living crisis has affected those who provide or receive unpaid care.

Conclusion

While evidence is still emerging, we can draw on information about household finances before the cost of living crisis to assess its likely effects. Households where someone provides or receives unpaid care are, in general, likely to consume more energy at home. As energy prices are rising significantly, this implies that these households will be disproportionately affected.

Working age households are likely to be more reliant on social security income and limited in how they can respond to real-terms falls in earnings by working more hours because of their care commitments. This means that the extent to which government support offsets a household’s rising energy bills is of particular importance for unpaid carers and care recipients.

While individual circumstances will vary, few in this group will be better off than they were this time last year.

Where can I find out more?

• Unpaid carers changing the systems that trap them in poverty: Article from the Joseph Rowntree Foundation.
• ‘Seismic’ impact of the cost of living crisis on disabled people: Report from the Welsh Parliament.
• From disability to destitution: Report by Tom Clark and Peter Matejic for the Joseph Rowntree Foundation.
• The high cost of unpaid care by young people: health and economic impacts of providing unpaid care: BMC public health report.

Who are experts on this question?

• Nicola Brimblecombe
• Linda Pickard
• Emma Congreve
• Martin Knapp
• Tom Clark

Author: Robert Watts

Picture by Chinnapong on iStock

The post How is the cost of living crisis affecting unpaid care? appeared first on Economics Observatory.

The currency had yet to go through decimalisation and computers were human beings who did complex computations.

In this article, using a contemporary lens, we review how the UK economy has been transformed since 1952 – and where one or two things don’t seem to have changed much.

Table 1: The UK economy, 1952 versus 2022

Sources: Bank of England; Higher Education Statistics Agency; Office for National Statistics; Mitchell, 1988; Turner, 2010; World Inequality Database.
Notes: Where data for 2022 are not available yet, data for 2021 are used.

The health and wealth of the nation

The UK economy has grown by 332% over the past 70 years as measured by real GDP per capita. Therefore, in purely material terms, UK citizens in 2022 are much better off than in 1952.

The increased wealth of the nation is also more evenly distributed than it was in 1952. For example, the top 1% of wealth holders then held nearly half the wealth. Today, that figure is close to 20%.

As can also be seen from Table 1, life expectancy has dramatically improved over the past 70 years. In 1952, the average man died about three years after retiring. Today, life expectancy in the UK is nearly 82, on average.

Infant mortality, another indicator of improved health, has fallen from 29.1 deaths per 1,000 live births to just 3.4. These improvements in life expectancy and infant mortality have their origins in improvements in healthcare provision, better nutrition, reduced pollution and developments in pharmaceutical and medical technology.

Ultimately, the increased wealth of the nation has been a fundamental driver of these improvements in health outcomes. The National Health Service, created just four years before the coronation, has played an important role in providing universal access to healthcare and therefore to these improvements.

The rise in life expectancy has created difficulties for both the government and employers when it comes to pension provision. The National Insurance Act of 1946 set the state pension age for men at 65 and women at 60. Employers and pension schemes quickly followed suit.

These retirement ages made economic sense in 1952, but as people have lived longer, the cost to the state and the burden on pension schemes has meant that state retirement ages have been creeping upwards. Employers have dealt with increased longevity by moving away from defined benefit pension schemes over the past couple of decades.

End of growth?

The increased GDP per capita of the UK since 1952 has largely come as a result of improvements in productivity. Productivity in the UK enjoyed a halcyon period of growth in the 1950s and 1960s.

This slowed somewhat after the 1970s and into the 1990s. But since the global financial crisis of 2007-09, UK productivity growth – and hence economic growth – has been at its lowest rate in 250 years (Crafts and Mills, 2020).

So, is this unprecedented fall in UK productivity growth temporary or permanent? If it is the latter, then this has major consequences for policy-makers who have operated in a world of economic growth for decades.

Economic historians suggest that the UK’s low productivity in recent years has been the culmination of an adverse set of circumstances – the worst financial crisis in the country’s history, Brexit and the weakening impact of information and communications technology on productivity (Crafts and Mills, 2020).

Indeed, the productivity growth that the UK has enjoyed since 1952 can be largely attributed to the technological revolution of the computer, which had transformed business practices by the 1990s, and then the internet, which transformed commerce.

The recovery of productivity growth, and the performance of the UK economy, will largely be determined by whether there is another technological revolution.

Techno-pessimists argue that the effect of innovation and new technologies, such as artificial intelligence (AI) and nanotechnology, on productivity and economic growth will be much less than it was in the past (Gordon, 2016). In other words, the 2020s will not repeat the productivity growth witnessed in the 1950s and beyond.

On the other hand, techno-optimists argue that productivity growth in the early years of general purpose technologies such as AI is underestimated (Brynjolfsson et al, 2020).

The UK’s poor productivity performance may be exaggerated because GDP is not a great measure for the new digital age. Some argue that the mismeasurement of GDP arising from the digital revolution means that we are likely to be underestimating productivity growth (Coyle, 2018).

Environmental sustainability

GDP is not everything (Coyle, 2016). It fails to take account of natural capital – the environment. A nation’s GDP may be soaring, but it may come at a great environmental cost. So, has the UK’s economic performance come at the expense of environmental degradation?

In early December 1952, the Great Smog of London hit the capital for five days. A combination of unusually cold temperatures, fog and a lack of wind combined with pollution from coal fires and coal-fired power stations to create possibly one of the most severe smog episodes that London has ever experienced.

The smog caused severe respiratory disease, which contributed to the death of approximately 12,000 people and 100,000 people falling ill (Stone, 2002; Bell et al, 2004). It also had long-term health effects on children in utero and new-born infants (Bharadwaj, 2016).

Recent research means that we know that coal pollution had major negative effects on the economy. Coal pollution in the UK had major adverse effects on infant mortality and child development (Beach and Hanlon, 2018; Bailey et al, 2018). The industrial use of coal also had a major negative effect on employment growth in UK cities between 1851 and 1911 (Hanlon, 2020).

The Great Smog was instrumental in the passage of a series of clean air acts, which sought to replace coal fires with alternative forms of heating. 1952 was the apex of employment in the coal industry. As can be seen from Table 1, nearly three-quarters of a million people (mainly men) were employed in coal mining in 1952. By 2022, less than 1,000 were employed by UK mines. Coal went from supplying 88.5% of the country’s energy needs in 1952 to about 6.5% in 2022.

Cost of living crisis

Before we leave our retrospective look at 1952, one striking parallel in Table 1 is that inflation in 1952 was as high as in 2022. In other words, it appears that some things have not changed about the UK economy.

High inflation in 1951 and 1952 was attributable to a boom in world commodity prices caused by an inventory build-up in advance of the Korean War (Dow, 1998; Radetzki, 2006). The end of that conflict in 1953 ushered in a period of low inflation and stable commodity prices until the 1970s.

The parallels with 2022 are remarkable. A post-pandemic boom and the Ukraine war have pushed commodity prices to high levels, feeding into inflation. This historical analogue might suggest that inflation will fall rapidly next year.

But unlike in the early 1950s, the inflation of 2022 has been preceded by government largesse to help the economy to recover from the pandemic. This might mean that high inflation will not be as transitory as we may wish.

We must hope that high inflation will be brought under control in the early days of King Charles III. But if policy-makers repeat the mistakes of the 1970s, high inflation might only be tamed in the reign of King William V.

Where can I find out more?

• The Great Smog of 1952: A short documentary on London’s big pollution event in December 1952.

• Why does productivity matter? A Productivity Puzzles podcast with Bart van Ark, Andy Haldane, Kate Barker and Nick Crafts.

Who are experts on this question?

• Stephen Broadberry
• Nick Crafts
• Diane Coyle
• Jagjit Chadha

Author: John Turner, Queen’s University Belfast

Editor's note: This is an update of the article Platinum Jubilee: how has the UK economy changed over the past 70 years?, first published on 1 June 2022

Photo by PicturePartners for iStock

The post How did the UK economy change during the second Elizabethan age? appeared first on Economics Observatory.

On Monday, the Conservative Party leadership contest finally came to an end. Liz Truss emerged victorious, gaining 81,326 votes (57.4%) from party members, with former chancellor, Rishi Sunak, backed by 60,399 (42.6%) voters.

But there is to be no honeymoon period for the new prime minister, not least with the passing of Queen Elizabeth, just two days after inviting Truss to form a government. Soaring energy and food prices, the war in Ukraine and issues around the Northern Ireland protocol make for an in-tray few would envy. Truss’s reaction to these challenges – among many others – will quickly define opinions among her own MPs, international leaders and the public.

She has already announced her new government’s response to the energy crisis. The UK energy price cap will be fixed at £2,500 a year for a typical home for the next two years. According to the prime minister, the policy will save the average household £1,000 a year and comes in addition to the £400 energy bill discount announced earlier this year.

Businesses are also to be offered some government protection. They will see their energy costs capped at the same price per unit as households for six months (from October). This will then be reviewed, with possible additional protection to be offered to businesses in more vulnerable sectors.

Crucially, this intervention will not be funded via a windfall tax on energy companies’ excess profits, despite renewed calls to do so from the Labour Party. Instead, the scheme – which could cost in the region of £150 billion over the two years – will be financed via government borrowing. This will have significant and long-lasting effects on the UK’s public finances and future fiscal strategy.

Trust in me

For the prime minister to gain buy-in for this and other policies from the public, rebuilding trust in government will be essential. The importance of trust for effective policy-making is discussed by Chris Dann (London School of Economics) in a recent Economics Observatory piece.

If the government is perceived to be trustworthy, people will be more likely to comply with public policies via consent, such as paying taxes and following the rule of law. As Chris highlights, if we think of state capacity broadly as ’the government’s ability to accomplish its intended policy goals’, then compliance – and therefore trust – is critical.

But the latest data paint a dire picture. In the UK, only 35% of the people trust the government (according to these data from the Office for National Statistics, ONS). This is well below the OECD average of 41%.

Opinions on Westminster seem to be particularly negative compared with local administrations. Around 42% of people trust their local government; and trust is even higher in the civil service, at 55%. Political parties are the institutions in which the public places the lowest level of trust, at only 20% (see Figure 1).

Figure 1: Trust in political institutions

Source: ONS

Clearly, Liz Truss faces a large challenge in rebuilding trust among the public in the UK. This will be vital for the success of her premiership, but also for developing a better long-term relationship between the state and the people. As the country faces significant challenges, such as the current cost of living crisis, it is important for people to believe that those governing have their best interests at heart.

As Chris points out, developing a greater commitment to procedural fairness and amplifying people’s voices in the political process are key. This will help to ensure that policy decisions are seen as being legitimate, strengthening trust.

Pale shelter

The announcement of the energy bill plan will have come as a relief to many who face much increased costs. But as highlighted by two new Observatory articles this week, not all households are affected by the cost of living crisis equally. Two groups that are likely to be disproportionately hurt are disabled people and those already living close to or below the poverty line.

As outlined by Jennifer Remnant (University of Strathclyde), people with disabilities are more likely to face higher household bills already – whether because of extra transport costs or the need for specialist equipment or additional heating. What’s more, they are often excluded from full economic participation, particularly employment.

Benefits, designed to offer support, are of limited assistance as they are falling behind the cost of living. This also affects poorer households, as emphasised by Helen Barnard (Joseph Rowntree Foundation). Individuals with fewer resources are more likely to take on debt to cover essential bills and goods, and this extends the effects of the cost of living crisis and increases the likelihood of falling into poverty.

Hard bargain

With the prices of essentials such as food and other basic household items going up at an alarming rate, some politicians have suggested that ‘looking for bargains’ is the answer. But is this even possible? In another new article, our director Richard Davies explores whether inflation is avoidable and if, by shopping carefully, savvy customers can keep their food bills down.

Drilling into the micro data, Richard finds that many of the prices of bargain options are going up faster than those of higher-cost equivalents. Those who buy goods in the cheapest three baskets of goods (the 10th, 20th and 30th percentiles) are seeing higher rates of inflation than those at the top (the 70th, 80th and 90th percentiles). In short, prices have gone up more for families who already shop for bargain products (see Figure 2).

Figure 2: Average inflation rates, consumer price baskets

Sources: ONS and Davies, 2022

The key issue is that eventually, there are no cheaper options. At some point, the bargain-hunters will end up with much of their shopping taken from the cheapest possible value ranges. And while historically prices in this range have risen more slowly, with the UK’s latest bout of inflation, this is no longer the case.

Winter is coming

For now, at least, some of the pressure caused by rising energy bills may have been eased. But for families and businesses across the country, the months ahead will still be difficult. Prime minister Truss and her new cabinet will need to find a way to mitigate the worst effects of inflation, which Bank of England forecasts suggest could reach 13% by the end of the year.

There are also concerns that tightening monetary policy could plunge the country into a recession, which is likely to bring with it rising unemployment, lower investment and diminished tax revenue to fund public services.

Finding the balance between managing the cost of living crisis and protecting the economy presents a daunting task for UK policy-makers. Failing to rise to the challenge will have serious implications not only for Truss and the Conservative Party, but the country as a whole.

Observatory news

The Festival of Economics will be returning to Bristol on Monday 14 to Thursday 17 November. We’re delighted to announce a packed programme of talks and events, details of which can be found here.

And finally, as the nation enters a period of mourning, here’s a reminder of what’s changed and what hasn’t in the UK economy during the 70 years of the second Elizabethan age. John Turner (Queen’s University Belfast), one of our lead editors, wrote this piece to mark Queen Elizabeth’s Platinum Jubilee back in the summer.

Author: Charlie Meyrick

Image by pesian1801 for iStock

The post A matter of trust appeared first on Economics Observatory.

Like the Covid-19 pandemic, these are challenges that affect the whole country but not in the same way or to the same degree. A common thread is that they each affect individuals and households on low incomes far worse than those with more money.

As the temperature soared in July, the BBC released new analysis showing that people in deprived areas were disproportionately living in places far hotter than nearby, less deprived neighbourhoods.

The impact of this was exacerbated by pre-existing health inequalities, meaning that those on low incomes were more likely to have conditions that are aggravated by heat. They also tend to live in poor quality housing and lack the cash to spend on things that can help with the heat – such as a fan or an ice lolly.

Similarly, the high inflation driving the cost of living crisis is a global phenomenon, but the degree of exposure to it in the UK has been increased by policy choices. Before the pandemic, there were sharp rises in the numbers of people living in deep poverty (with incomes below 40% of median) and destitution (those with incomes so low they can’t afford the bare essentials such as food, shelter and clothing).

A decade of cuts and freezes to social security eroded support for people on low incomes, both in and out of work. Large numbers of workers were trapped in insecure, low-paid work with little chance of moving up to a better job. A dysfunctional housing market locked too many people into expensive, insecure, poor quality private rented housing. This is alongside a shortage of social housing and seemingly insurmountable barriers to ownership.

The economic impacts of the pandemic then fell most heavily on those who were already struggling. Many people on higher incomes were able to continue with well paid jobs, safely at home. Many were even able to build up savings as their leisure opportunities were curtailed by lockdowns and social restrictions.

By contrast, many on low incomes lost their jobs, saw their pay drop or were exposed to the higher risks of continuing with essential work in the community. Many also used up their savings and accrued debt trying to stay afloat.

The government’s decision to raise the rate of the main benefit – universal credit – gave significant protection to those receiving it during the pandemic. But the decision then to cut it again for those on the lowest incomes plunged many back into dire hardship. The universal credit cut imposed a drop in annual income of £1,000 for 5.5 million families – the biggest ever overnight cut to benefits.

As the cost of living crisis took hold, the ability of households to endure sharp price rises was therefore enormously unequal. The inflation rate they faced also varied.

Inflation has been driven up largely by the cost of essentials, particularly energy and food, on which poorer households spend far more of their budget than those on higher incomes. As overall inflation reached 9% in April, the effective inflation rate being experienced by those on the lowest income was already 10.9%, while those on the highest incomes faced a rate of only 7.9%.

The immediate impacts of this were evident in the numbers going without essentials such as food, heating or toiletries – seven million people, according to research carried out in May 2022 by the Joseph Rowntree Foundation (JRF).

There have also been spikes in the numbers turning to charities, such as food banks, to get by. The support package put in place by the government in May was very welcome, offering most low-income families additional support of about £1,200 (when added to previous announcements). This largely covered the rise in energy bills, but it is unlikely to be enough support for families facing many other cost rises and already in debt with average arrears of £1,600.

Going without daily essentials is, of course, appalling and can have long-term consequences for both physical and mental health. But the rise in debt and arrears, which has received less attention, is another deeply troubling consequence of the cost pressures bearing down on people.

Across the UK, 4.6 million people were already behind with bills in May, up a fifth compared with October 2021 (JRF, 2022). The average amount owed by low-income households in arrears was £1,600 and more than a million people were taking on debt just to cover essential bills.

Very worryingly, almost a fifth of low-income households were in debt to high-cost lenders including loan sharks, amounting to £3.5 billion in debt. Another £2.3 billion is owed to ‘buy now, pay later’ providers such as Klarna or Clearpay.

These debts will not disappear when inflation starts to fall and the economy returns to something closer to stability. The scope for many on low incomes either to save for future expenses or to pay off debt is severely constrained.

Debt and arrears also often have a significant impact on people’s mental health. Nearly half of people with problem debt also have a mental health problem and 40% say their finances have made their mental health problems worse, according to the Money and Mental Health Policy Institute. Financial difficulties also affect recovery rates, with people 4.2 times as likely still to suffer from depression after 18 months if they are in problem debt.

National crises and traumas always have long-lasting consequences that affect people across all income groups and parts of the country. But these are often disproportionately severe and long-lasting for those with fewer financial and other resources.

Children from low-income families experienced greater pandemic-related learning loss than those from better off areas. People in deprived areas are more likely to suffer from long Covid.

The current cost of living crisis is similarly likely to cast a deep shadow over people on low incomes, long after those who are better off feel that the sun has come out once again.

Where can I find out more?

• Not heating, eating or meeting bills: Managing a cost of living crisis on a low income: Report by the Joseph Rowntree Foundation.

• Going without: Deepening poverty in the UK: Report on the effects of deep poverty and forgoing essentials by the Joseph Rowntree Foundation.

• The facts – links between mental health and money problems: Money and Mental Health Institute.

Which organisations are experts on this question?

• Joseph Rowntree Foundation
• Citizens Advice
• Stepchange
• Resolution Foundation

Author: Helen Barnard

Picture by Richard Johnson on iStock

The post How might the cost of living crisis affect long-term poverty? appeared first on Economics Observatory.

Just under half of all people living in poverty in the UK are disabled or living with a disabled person. Prior to the recent and extreme increases in energy costs, disabled people are already more likely to live in a cold home during the winter months.

As a group, disabled people can expect to struggle to cover their food costs more than their non-disabled counterparts. Given that we are all likely to feel the crunch in the coming months, we can expect that the cost of living crisis is going to have a catastrophic effect on people who are already struggling to get by.

This article explores the two central and interrelated reasons for the relative poverty of disabled people in comparison with their non-disabled peers. These are the extra costs of being disabled (in a society that is organised for non-disabled people); and the exclusion of disabled people from full economic participation.

Why is it more expensive to be disabled?

There are several ‘hidden’ costs to being disabled (Smith et al, 2004). Disabled individuals and their families spend more on essential goods and services, such as heating, insurance, equipment, travel, food and therapies. Basics such as travel become more expensive when one has to finance a carer’s travel alongside one’s own, or when travelling by train or taxi rather than by bus for accessibility reasons (Schmocker et al, 2008).

Some disabled people – for example, those recovering from cancer treatments – will require additional heating in their house or have to buy more clothes to accommodate their fluctuating weight.

Others use assistive technologies, which need regular charging, or need to eat convenience food rather than raw or unprepared food. This comes with additional expense, as do condition-specific specialist diets.

Why can't disabled people just earn more money?

Disabled people often face economic exclusion. This results from long-held prejudices about disability and the ability of disabled individuals to participate equally in paid employment (Barnes and Mercer, 2005; Grover and Piggott, 2015; Remnant, 2019).

As with other social systems, workplaces and stereotypes of what makes an ‘ideal worker’ have been developed in opposition to disabled people (Foster and Vass, 2013; Sang et al, 2015). Similarly, the legislative context of what it is to be disabled in the UK is predicated on an individual’s capacity to undertake paid work.

Historically, workers either recovered from illness and returned to work, or departed from the workforce permanently due to death or disability. Workplace policies were developed on this functionalist assumption: that disabled and ill workers would assume the ‘sick role’, whereby they were relieved of normal duties such as work while they recover or leave (Parsons, 1951).

Although this assumption is out of date, as it does not incorporate the more commonly experienced fluctuating or long-term health conditions found in the contemporary and ageing UK workforce, it can be identified in workplace assumptions about disabled people’s capacity to work (Remnant, 2019).

These issues manifest in what is known as the ‘disability employment gap’. This is the gap between the proportions of disabled working age people in paid employment compared with their non-disabled counterparts. This gap is around 20% for women and 30% for men.

Disabled people experiencing multiple conditions co-morbidly or those with mental health conditions face higher risks of being unemployed. This is alongside replicating issues faced by many in the wider population, such as not having qualifications, being older and living in areas with struggling labour markets.

The consistent gap between the employment rate of disabled people of working age and their non-disabled peers is layered with levels of ageism, which seem to be inherent in ‘ableism’ (van der Horst and Vickerstaff, 2021).

For example, research shows that for both disabled and older workers, employers deliver positive rhetoric but harbour negative views personally about the capacity of those workers (Hutton et al, 2012). In the current competitive and individualised labour market, older, ill or disabled workers are likely to end up competing against younger, non-disabled workers for scarce opportunities.

Although the proportion of disabled people in employment has started to increase again, this should be viewed critically. Changes in this statistic are driven both by disability prevalence within the working age population and by the overall employment rate of the working age population inclusive of non-disabled people.

This also requires us to reflect on the quality of work made available to disabled people. They are also likely to be under-employed. This can mean working in lower-skilled occupations, working part-time (and subsequently fewer hours) and/or working for themselves.

Even before the pandemic, the labour market context was increasingly defined by precarity, on-demand and self-employed work (Standing, 2014). This has only been exacerbated by the pandemic.

Lockdowns triggered major labour market changes, temporarily devastating sectors such as aviation and hospitality, while increasing demand for drivers, couriers and delivery services (Fana et al, 2020). These are occupations largely made up of casual workers who do not have recourse to sick pay, despite having faced the increased risks of being exposed to Covid-19.

The opportunities for economic participation available to disabled people are decidedly limited. This is relevant to our understandings of disabled individuals’ domestic budgets because if people are not in paid work, they are likely to require recourse to state welfare provision.

Can't disabled people get welfare benefits?

Although there are welfare benefits available in the UK to disabled people and people experiencing long-term ill health, there is extensive evidence to suggest that accessing them is increasingly difficult (Garthwaite, 2011).

This is in terms of how to navigate the complexities of the websites and forms necessary to claim, as well as understanding the nature of welfare distribution and the various types of welfare and related eligibility criteria. Research continues to find that people who become ill or impaired during their working life find it very difficult to identify what they are entitled to or how they can claim it (Saffer et al, 2018; Moffatt et al, 2012).

For disabled people of working age, there are two key welfare benefits available based on impairment and/or long-term ill health: personalised independence payments (PIP); and employment and support allowance (ESA).

PIP (which succeeded the disability living allowance, DLA) is paid in recognition of the additional costs of being disabled and is available to disabled people in and out of work. Qualifying for PIP – since it was introduced in 2013 – has become increasingly conditional, with one-third of people who had previously qualified for DLA having their claims rejected (Cross, 2013; Roulstone, 2015).

ESA is an income-replacing welfare benefit, designed for people unable to work due to impairment or ill health. Claiming ESA is also conditional: it is contingent on the outcome of medical assessments and, sometimes, participation in ‘work-related activities’.

An irony of ESA is that it can inhibit a disabled person seeking paid work that they can manage around their symptoms. This is because if they earn over a certain amount, it jeopardises their continuing receipt of the benefit.

Recipients can only work up to 16 hours per week before their ESA is reduced, which is further complicated if they work on a freelance basis. Freelance and self-employed work can often result in inconsistent payment amounts month to month, which can lead to continued benefit payments being withheld.

These issues are compounded by the widely evidenced view that UK welfare benefits have, for some time, not fully covered the cost of living. This was made apparent in the periods of lockdown and unemployment during the pandemic.

A £20 uplift was added to universal credit, which is paid alongside some ESA payments, on the basis that new claimants could not afford to get by on the standard payments. These are payments that disabled people have been living off for years.

Can it get worse?

In short, yes. Unless something changes, the situation will deteriorate for disabled people.

The windfall tax mooted by Rishi Sunak when he was chancellor would be used to provide targeted financial support to those who need it most. This included a £650 one-off payment to low-income households, £300 payments to pensioners and £150 payments to non-means-tested disability benefit recipients (Lea, 2022).

But these payments, which are not received by all disabled people, are likely to be insufficient, given the complexity of their work/welfare status.

High inflation has been outstripping both wages and benefit increases, resulting in a reduction in disposable income for UK households. Huge increases in energy bills are not sustainable for many low-income households, such as those with disabled and unwell members (Khan, 2022).

This is a disastrous time for disabled people, particularly as many feel unprotected now that the social restrictions imposed during the pandemic have been lifted. The virus is still in evidence, but masks are not.

We run the risk of entering an indefinite phase of eugenics-by-negligence by allowing the continued rise of poverty and health inequalities (Limb, 2022a; 2022b). Anyone can become disabled or impaired during their lifetime, temporarily or indefinitely. These issues are not a matter of ‘them and us’: it is we. We need to do something.

Where can I find out more?

• Disabled people: Resources and reports from the Joseph Rowntree Foundation.
• Nearly half of everyone in poverty is either a disabled person or lives with a disabled person: Article from Disability Rights UK.
• To those who wish to penalise poor people, cold and hunger are signs of a perfect system: Article by Frances Ryan in The Guardian

Who are experts on this question?

• Disability Rights UK
• Disabled People Against the Cuts
• Frances Ryan
• Tom Shakespeare
• Roger Stancliffe
• Chris Hatton
• Gwynnyth Llewellyn
• Tania King
• Vaso Totsika
• Zoe Aitken
• Anne Kavanagh
• Carol Thomas

Author: Jennifer Remnant

Picture by 24K-Production on iStock

The post How is the cost of living crisis affecting disabled people in the UK? appeared first on Economics Observatory.

Some claim that inflation is unavoidable and that it is inherently unequal since poorer households often have fewer options in terms of shopping and essential items take up a bigger share of their incomes. Others suggest that by looking around for bargains, even the cash-strapped should be able to avoid the worst price rises.

This article uses the latest data to test these two points of view: is inflation avoidable?

Figure 1: The UK's consumer price index, 1988-2022

Source: Office for National Statistics (ONS)

The UK’s three measures of inflation – the consumer price index (CPI), the consumer price index including housing (CPIH) and the retail price index (RPI) – are closely related. They are all currently over 10% in the UK.

These measures are the country’s most essential economic yardstick – since they are hard-wired into policy decisions. Inflation is used to uprate pensions, public sector pay and to set the pay-out on inflation-protected debt.

Inflation also influences the Bank of England’s decisions in interest rates, and the payments made and received by savers and borrowers across the economy. The official figures are based on records for over 100,000 prices, which are collected each month by the ONS. Knitting together these underlying historical files (known as ‘price quotes’) results in a database of over 40 million prices going back to 1988. (More detail on the data is available in this paper and the files can be found on my site, here.)

The argument that high prices can be avoided by judicious shopping rests on the common-sense observation that for any given item there will be many options – and many prices – on offer.

To take a late summer example, consider a trusted gardener’s tool: the garden spade. So far this year, the ONS has already collected almost 1,000 prices for garden spades across the country. These range from £5.99 to £44.99:  £14.99 is the most common (modal) price; £19.99 is the middle of the distribution (the median); and the average (mean) price is £21.73 (see Figure 2).

Of course, there is likely to be a difference in quality between a humble spade bought for less than £10 and a fancy one for over £40. But the basic economic function of the product is the same.

If all we cared about in the economy was spades, then the ‘thrift’ argument would be right. Massive savings are possible if you go for bargain basement goods.

Figure 2: Price of different garden spades

Source: ONS

But we care about more than garden tools, and so to measure the cost of living in a meaningful way, we need to track a bundle of items. To simplify comparisons over time, I focus here on the prices of goods that were included back in the 1988 CPI and are still used today. There are 106 of these perennial items and a table summarising them is available here.

This bundle includes a range of products – food and drink, tobacco, homewares, clothing, healthcare products and services – that people across the UK have been buying for the past 34 years.

To follow how shoppers of various types – from those that opt for the cheapest options, to those that pay for luxury – we can track the distribution of prices over time. Figure 3 identify nine spending levels, corresponding to evenly spaced points on the price distribution.

In 2022, the group opting for the lowest priced bargains (buying at the 10^th percentile) could get the entire bundle for £1,650. Those buying the highest-priced options (the 90^th percentile) would need to spend over £7,000. Those in the middle group (the 50^th percentile) would spend £3,500.

The fact that the bundles include one-off purchases – pushchairs, for example – that have a wide range of prices magnifies the spread. There is a wide range of prices for many goods, and so there are savings from ‘trading down’ to comparable, but lower priced, items.

Over the long run, the lower end of prices has risen less quickly, as might be expected, with the long-run inflation rate for our best bargain bundle close to 2%. Again, this seems to support the intuitive thrift argument: over the long run, the price of the cheapest goods tends to rise slowly. (This price distributions for all of the goods can be seen in this visualisation).

Figure 3: Consumer bundles by price decile, 1988-2022

Source: ONS

High costs for low prices

So, should the spread of prices in the economy make us less worried about inflation? There are three reasons why not.

The first is that for many goods, inflation is impossible to avoid. We can see this by comparing the plots below for garden spades and driving lessons (Figures 4A/4B).

Over the past 30 years, the spread of spade prices has changed very little: you could buy one for £15 in 1990 and you can today. But for driving lessons, the pattern is different. As time passes, prices rise at the top and disappear at the bottom. So, while driving lessons priced at £11 per hour were common in 1990, the cheapest today is closer to £20.

Learning to drive can be an economic and social necessity – if you live rurally, for example – and the only option is to pay higher prices. Energy markets, covered extensively on the Economics Observatory site, are another example of this.

Figure 4: Price evolution, 1990-2022

Panel A: Garden spades

Panel B: Driving lessons (one hour)

Source: ONS and author's calculations

The second problem is that you can’t keep switching to ever cheaper options. At some point those driven to find bargains will end up with much of their shopping the bargain bucket. And while historically, prices here have risen more slowly, that pattern has evaporated with the UK’s latest bout of inflation.

In fact, those that buy goods in the cheapest three buckets of goods (the 10^th, 20^th and 30^th percentiles) are seeing higher rates of inflation than those at the top (the 70^th, 80^th and 90^th percentiles). Families that shop at the bottom now face higher inflation than those that shop at the top.

Figure 5:  Average inflation rates, consumer price baskets

Source: ONS and author's calculations

Note: Buckets defined as average across inflation rates for decile groups (Bottom = 10^th, 20^th, 30^th; Middle = 40^th, 50^th, 60^th, Top = 70^th, 80^th, 90^th).

The third problem is volatility. To see why this matters, step back and consider why inflation matters. In part, it is due to the costs that workers and shops face – often referred to as ‘shoe-leather’ and ‘menu’ costs – when trying to keep up with rising prices.

But it is unexpected shifts in inflation that are especially damaging, since these undermine plans in the economy – from wages rates to investment decisions. This is why John Maynard Keynes saw unanticipated inflation as the most malign type, writing about the ‘precarious life of the worker’ and ‘excessive windfalls’ to profiteers (Keynes, 1956).

As the UK’s inflation targeting regime was set up, volatility and the violation of expectations were seen as a vital target. Useful, and very readable, articles from this period include Leigh-Pemberton (1992) and Briault (1995). Price rises are supposed to be low, and predictable.

Assessed over short windows of time, prices are highly volatile, as a series of seminal studies focused on US data by, Emi Nakamura and Jón Steinsson (2008), Pete Klenow (2010), and Virgiliu Midrigan (2011) have shown. Some of the reasons why are intuitive – firms offer temporary sales and when multiproduct companies decide to change prices, they often change them all.

The important point here is that prices, as well as trending up with inflation, are in constant flux. And the problem is that the price bundles for the perennial goods shown here seem to have a lot of volatility at the bottom. The long-run standard deviation (the distance from the average) of the cheapest food prices is around 11% higher than for the most expensive, for example.

Other categories, including services, show volatility at the top and bottom, but less in the middle. The concern is that those shopping at the low end are likely to pay a high price in terms of inflation uncertainty.

In summary, there are elements of truth in both perspectives on prices. A capitalist economy provides choice, and we have seen a huge ‘fanning out’ of prices in the UK over the past 30 years. So, many families will be able to make savings by trading down – opting for bargain basement options and forgoing luxury. Indeed, this intuitive response to higher prices seems to be playing out across the economy, as evidence from supermarkets and consultancies shows.

But this does not reduce the problem, nor ease the headache for the Bank of England and HM Treasury. You can’t scrimp forever, and the analysis here shows that, once you reach the bargain basement, prices are rising fast and are volatile. The latest inflation in the UK, the worst since the 1970s, is one in which those at the bottom are paying some of this highest costs.

Technical notes/data access

The data used in this essay were first published as Davies, 2021. I update the databases each month and make them openly available via my website here. Please get in touch if you have questions related to a research or policy project.

The specific numbers used in these figures, together with the JSON spec that draws the charts (using Vega), are all available on my GitHub page, here.

Where can I find out more?

• Inflation and price indices: Latest data and updates from the ONS.
• How is inflation affecting your household costs? ONS inflation calculator.

Who are experts on this question?

• Jagjit Chadha
• Richard Davies
• Huw Dixon
• Michael McMahon
• Xavier Jaravel

Author: Richard Davies

The post Is inflation avoidable? appeared first on Economics Observatory.