The hidden costs of lower inflation

With one recent rate rise under its belt and another virtually promised for later this year, the Monetary Policy Committee re-asserted its low inflation credentials in the summer. While higher energy costs are the main source of price pressures, the Bank of England also drew attention to the fact that GDP is growing at, or just above, trend. This implies that the amount of spare capacity in the economy is diminishing, which is usually a precursor to an increase in prices.

There is no argument about the contribution of energy to the authorities’ inflation worries. For example, in the past three months, when the Consumer Price Index (CPI) has risen at an annual rate of 2.4 per cent, the energy component (which accounts for 6.7 per cent of the total) increased by 19.5 per cent. If the CPI continues to rise on the back of higher energy costs, it raises the possibility of second-round effects, and with it the spectre of a return to the wage-price spirals of the past.

Spending power is a function of the number of people working and in receipt of benefits and the incomes they receive. But, as companies try to keep prices down by squeezing costs, the labour force often takes the strain. This comes in the form of slower growth of earnings, or as a reduction in the numbers employed. To a certain extent, this has been offset by a continued increase in total employment, but much of this is thought to be attributable to migrant workers filling low-wage jobs, and some of this money is sent back to their country of origin and not spent here.

But this does not tell the whole story because even if wages and salaries do rise to keep pace with inflation, this does not necessarily convert into greater spending power. There are deductions that have to be made for taxes to turn gross income into disposable income. Also, well-publicised factors such as fiscal drag and sharp increases in council taxes, mean that government is taking a bigger share of household incomes.

More interesting than disposable income is discretionary income, which is reached after deducting household expenditure on compulsory items, such as gas and electricity. This is where inflation bites into personal-sector budgets because utility bills have been rising in double digits compared with the single-digit increases in disposable incomes.

So, already the spending power is starting to look more fragile than wages growth might imply, but this is not the last adjustment. What has been apparent over the past few years is the substantial stimulus consumers have had from borrowing. Between 2002 and 2005, borrowing added between 10 per cent and 15 per cent to discretionary income, which boosted discretionary spending pow-er. It is this contribution to spending power that now looks to be most at risk.

The £1 trillion debt overhang will constrain new borrowing, which is already weakening. Higher interest rates not only add to the existing servicing burden, but also make new borrowing less attractive. Without access to additional funds to shore up slow-income growth, questions have to be raised about consumers’ ability to sustain spending, and therefore GDP growth. Higher base-rates may dampen down inflation, but they are likely to be counter-productive for jobs and spending.