UK: Bank Must Share Blame for the Drop in Real Incomes

According to the Office for National Statistics, the fall in households’ real disposable incomes last year was the biggest since 1977.

There may be worse to come. That comparison was based on a 0.8% drop in real incomes in 2010. Yet the fall over the 12 months to the first quarter of this year, 2.7%, was not only bigger but is on course to beat the drop of just over 2% in 1977. We could be heading for a post-war record.

There is, as always, a health warning to be attached to early-release data like this. Not only are revisions likely in future but, while most people would accept that their real (after-inflation) incomes have dropped on an individual basis, there has been some compensation at the aggregate level from a strong rise in numbers in work.

Even so, we are in a topsy-turvy period. For most people, recovery is proving far more painful than recession. Real incomes held up surprisingly well in the recession but are falling sharply in the recovery.

Part of the reason for this is fiscal. Labour supported the economy in the recession by cutting Vat, returning it to its previous 17.5% level at the start of last year. So, with George Osborne’s hike to 20% in January, Vat was hiked twice in the space of little more than a year.

Mostly, however, it is monetary. Had the Bank of England kept inflation under control at 2%, real incomes would not now be falling. So when Sir Mervyn King, its governor, says as he did again recently that there was no alternative to the squeeze on living standards, there was, or at least an alternative to its intensity. We should also remember that if the drop in living standards was part of some rebalancing grand plan, it was not in the Bank’s forecasts, at least until recently.

A good way of assessing the relative contribution of tax hikes and other factors to the squeeze is by looking at the Bank’s old target measure, so-called RPIX, the retail prices index excluding mortgage interest payments. It is running at 5.3%. Take out indirect tax changes and it comes down to 3.9%. Three-quarters of the inflation pushing down real incomes is monetary, one quarter fiscal.

A few days ago the Bank had a significant rap over the knuckles about this. The Bank for International Settlements in Basel is the central bankers’ bank. Its record on warning of the crisis before it happened was second to none.

Now it thinks central banks, in keeping interest rates close to record lows, are living on borrowed time and in its annual report last week had particularly harsh words for the Bank.

“Controlling inflation in the long term will require policy tightening,” it said. “And with short-term inflation up, that means a quicker normalisation of policy rates … In the UK, CPI inflation has exceeded the Bank of England’s 2% target since December 2009, reaching a peak of 4.5% in April 2011. As yet, there has been no move by the MPC but one wonders how long its current policy can be sustained.”

There are, before anybody says it, many reasons not to raise interest rates. Growth is weak, the money supply subdued and there is no sign of anything more alarming than a gentle upward creep in pay settlements. For the minority of households with mortgages, roughly 10m out of 26m, a rate hike would intensify the squeeze.

There are also big dangers on the other side, however. Last week Citi, the bank, reported its latest survey of household inflation expectations, carried out by YouGov, the pollsters. It showed that people expect inflation over the medium-term, the next 5-10 years, to average 4.1%, up from 3.5% in May. Prices, they think, will be rising at twice the rate of the official target.

I do not blame them for this. Everything we have seen from the Bank in recent months suggests it has softened its anti-inflation resolve. Last week some MPC members were at it again, publicly flirting with the idea of more quantitative easing – electronically creating money – even with inflation at more than double the target.

Paul Tucker, the Bank’s deputy governor, was an honourable exception but the damage was done. Sterling weakened a little bit more; the pound’s weakness being the main route from higher international prices to higher inflation in Britain.

It is possible, of course, that people are too gloomy about the inflation outlook, and that they are in for a pleasant surprise when it comes back towards the 2% target. The Bank insists it is looking through the temporary factors that have pushed inflation up.

It is hard, though, to see too many lights at the end of the inflation tunnel. Big increases in domestic utility bills are in the pipeline, which will push inflation higher later in the year. Oil prices have fallen, though the effect on pump prices has been negligible, and oil perked up on the Greek vote in favour of austerity measures.

One reason for the latest drop in consumer confidence, which on the GfK-NOP measure fell sharply last month after a brief rise in May, is the current squeeze on incomes. Another is that people expect that squeeze to continue, because they have lost confidence in the Bank’s ability to keep inflation low. They think a temporary overshoot is becoming permanent.

Falling real incomes provide a grim backdrop for retailers and add to the pressure on the rest of the economy to deliver the export and investment performance needed for growth. Falling real incomes are a failure of policy. And most of the blame for that failure rests firmly with the Bank.

My regular column is available to subscribers on This is an excerpt.

This post originally appeared at David Smith’s EconomicsUK and is reproduced here with permission.