The squeeze intensifies

It has become commonplace to hear how the combination of high inflation, low wage growth and tax increases will severely squeeze household finances in the UK. Today, the Office for National Statistics provided some hard evidence (pdf) on the extent of this squeeze.

It reported that households’ real disposable incomes – total income from all sources less taxes and national insurance contributions, after allowing for inflation – fell by 0.8 per cent in the first quarter of 2011 and by 2.7 per cent over the last year. This annual fall is the largest recorded in the UK since 1977.

Real disposable income is basically a measure of households’ ability to increase their spending without reducing their saving or increasing their borrowing. So it is no surprise that household spending also fell over the last year, by 0.5 per cent in real terms.

The fall would have been greater, but for the saving ratio declining from 6.2 to 4.6 per cent. Households have chosen to save less in an attempt to maintain their living standards.

Although wage growth – at around 2 per cent – is low by historical standards, sterling’s decline in 2008 and 2009 may still be having a lingering effect on some import prices and the chancellor made the squeeze worse by increasing the standard rate of VAT from 17.5 to 20 per cent in January, high food and fuel prices are the main problem. They have boosted inflation, as measured by the consumer spending deflator, well over 5 per cent.

To the extent that these higher prices are the result of the strength of demand in emerging economies, there is little the UK can do about them.

The Monetary Policy Committee is torn between the need to raise interest rates to prevent higher inflation expectations becoming locked in and the knowledge that to do so now would add to the squeeze on household finances as mortgage payment went up.

For now it is rightly giving more weight to the negative effect of higher interest rates on demand and holding them at the record low level of 0.5 per cent.

If food and energy prices fall back later in the year and the squeeze on households’ spending power ends, then the MPC will claim it was right not to act. However, if they do not, and the squeeze persists, then the MPC’s dilemma will intensify.