Is the recent tumble in consumer spending here to stay?
As a nation of consumers, with household spending accounting for two thirds of UK output demand, a shift in consumer sentiment can make a big dent in overall economic performance. Until recently, UK consumers could be relied upon to hold the UK economy steady, but since the start of this year, spending seems to have taken a bit of a tumble (see Figure 1 below). Is this new trend here to stay and what does it mean for the broader economy?
Consumers have been facing headwinds for some time: real disposable income turned negative in Q3 last year (see Figure 1 below) as a weaker pound caused inflation to accelerate and wage growth remained subdued despite a tight labour market.
Faced with dwindling real disposable income, consumers have resorted to debt. Double-digit growth in consumer credit over the past year has raised concerns at the Bank of England that the current situation may be unsustainable, while the UK savings rate plummeted to a record low of 1.7% in the first quarter of 2017 (some of the fall in the saving ration is due to structural changes in the labour market such as the growth in self-employed workers, but even after taking those into account it is much lower than it has been for some time).
While the combination of negative real income growth and increased levels of consumer credit signals that consumption patterns of UK households are becoming increasingly unsustainable, the adjustment in consumer behaviour could be gradual, owing in part to the level of ‘noise’ in the economy.
Over the past year, the sheer volume of commentary about the uncertain course of the economy may have made households less sure about the course to take. Evidence from the US shows investors are currently taking less notice of policy uncertainty.
The level of noise in the UK has been higher than in the US and also increased significantly over the past year (see Figure 2 below - it depicts the ratio of the Economic Policy Uncertainty Index for the UK and the level of the implied 30-day volatility of the FTSE 100 index. There is a clear shift from mid-2016 onwards towards higher levels of this ratio. This implies that while commentators have increased the frequency of use of the term uncertainty to describe the economic and political situation, that has not translated into greater volatility in equity markets.). Faced with imprecise signals, households may have been acting on inertia.
Source: KPMG analysis based on data by Scott R. Baker, Nicholas Bloom and Steven J. Davis
Another explanation to support the view that we will see a relatively small adjustment in consumer spending is that households tend to smooth their consumption pattern if they believe a drop in income is only temporary. As inflation is expected to gradually ease while a tight labour market could finally push wages up, households may see some recovery in real earnings. Therefore, the current adjustment to spending may not need to be as steep.
The mood of consumers started to sour in 2015, but that has not always been followed with more spending restraint (see Figure 3 below). Unfortunately, there are reasons to believe that the recent drop may be different, as it coincides with heightened uncertainty as well as real falls in incomes and a meagre safety net in the form of savings.
Any decision by households to bolster their savings could have significant implications for overall economic growth. For example, our model shows that in the absence of any noteworthy increase to earnings, if households opted to raise the savings rate by 0.6 percentage points this could halt economic growth that quarter.
Taking all these factors together, we continue to believe that the adjustment to consumption will be gradual. Without an obvious trigger, households should gradually restrain their spending habits rather than switching them off, en masse.
The current outlook of weakening consumption may delay any Bank of England move to normalise UK interest rates. If more weak economic data comes to light it may be several months before policy rates increase in the UK.