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The writer is an external member of the Bank of England’s Monetary Policy Committee
An old mentor used to consult women’s dress sales when he wanted to know what was going on with the economy, because he thought women controlled the disposable income of many households. Simplified models such as this are dangerous, but he was right that you have to understand the consumer to understand the economy.
After all, consumption accounts for about two-thirds of GDP in most developed economies. It plays a key role in determining how much price- and wage-setting behaviours feed on one another.
This makes my job as a UK rate setter particularly challenging, because the UK is facing a consumption conundrum.
Consumption collapsed globally when the pandemic hit and remained weak when global energy and food prices spiked following Russia’s invasion of Ukraine. As these shocks have faded, global consumption has rebounded, but recovery in the UK trails that of many developed economies.
UK real consumption is roughly 1.5 per cent above pre-pandemic levels, compared with 13 per cent in the US. What doesn’t get spent is saved. As UK consumption remains tepid, the savings rate (savings as a proportion of income) has risen above historical averages to around 10 per cent. In the US the rate is roughly 5 per cent.
This is somewhat puzzling given that real incomes have been rising for more than a year, short- and medium-term household inflation expectations are near their historical averages, consumer confidence has broadly improved and the terms of trade shock have now unwound.
Three factors can explain the UK’s weak consumption and high savings rate. First, the successive shocks of the pandemic and a war in Ukraine sparked a cost of living crisis that probably prompted a rise in precautionary savings. There is evidence of this in the granular data on what households are buying. Discretionary spending remains well below pre-pandemic levels, particularly for big-ticket items. Households are holding off on buying washing machines and cars partly in order to build a rainy-day fund. After accounting for essential spending, consumers have increasingly chosen to save their disposable income rather than spend it on discretionary goods and services.
Restrictive monetary policy has dragged on consumption as well. Higher interest rates incentivise households to save more, borrow less and delay purchases. Evidence of this lies in the flow of household deposits out of easy-access savings accounts into fixed-term accounts in 2022-23.
Finally, as the Bank of England rate rose from record lows in 2021 so did mortgage and savings rates. Overall household income from interest on savings has increased over this rate-raising cycle. This is because the stock of household savings is greater than that of household mortgages. Higher BoE interest rates also do not feed through into most mortgage payments instantly.
Changes in overall income from interest have nevertheless dragged on consumption. Households with savings do not tend to increase their consumption much in response to rising savings incomes, while households with mortgages and other loans tend to reduce consumption materially in the face of higher borrowing costs.
The relative weights of these factors in damping consumption have implications for the economy and monetary policy. All else equal, as the base rate falls, the drag on growth from monetary policy wanes and the labour market strengthens, precautionary savings should diminish and consumption should rebound. Similarly, a rate-cutting cycle should reduce the incentives for households to delay consumption and save more. Savings could be released as pent-up demand.
But if the biggest factor is the impact of rates on household incomes, recovery could take much longer. While households have already seen much of the benefit from greater interest on savings, the full impact of higher interest rates on mortgage payments has not yet passed through. This means that as more mortgages reset at higher rates, consumption could continue to flag — even as interest rates fall.
We have no way to measure how much each individual factor is bearing on consumption. The risk of higher than expected consumption is that companies pass on costs more easily, buoying inflation and requiring restrictive monetary policy for longer. The risk of weaker consumption is below-target inflation, necessitating more rapid rate cuts. Given these risks, I believe a cautious, gradual approach to monetary easing is appropriate.