Cost of living crisis could slow household recovery

2nd December 2021

Research from PwC suggests the economy will be hit by a triple whammy of a climbing cost of living, higher interest rates and the end of pandemic-related support from the government, with weaker household spending likely to slow the recovery.

The analysis says more affluent households will be able to shake off the impact of rising prices, with an increase in spending “likely be concentrated on higher income households”. While the Office for National Statistics estimates prices are 4.2% higher than they were a year ago, PwC expects the rate to increase, saying: “The rise in the energy price cap and the reversal of the VAT cuts for hospitality and tourism create a perfect storm that is set to push headline inflation rates to around 5% and 6%”.

The UK economy continued its recovery in Q3 2021 but economic polarisation is likely to see a return to sluggish levels of growth as consumer spending is squeezed in 2022/23, according to new analysis from PwC.

UK output in September 2021 was just 0.6% lower than February 2020 levels due to a welcome acceleration in monthly growth. But sectoral data presents a stark picture of the uneven nature of the recovery, with the normalisation of everyday activity being the main driver of growth, according to the latest PwC UK Economic Outlook.

UK GDP growth is expected to remain strong in 2022, at around 4.5-5.1%, but our economists caution that this is primarily driven by the impact of base effects as the fall in output during the national lockdown a year ago skews the annual figures. Core underlying growth is expected to be relatively modest, marking a return to a low-growth period until at least 2023.

Jonathan Gilllham, Chief Economist at PwC UK, said “The UK economy is continuing to recover at a rapid rate, fuelled by the reopening of many sectors, but significant risks to recovery remain. There are already signs that this growth will become increasingly sluggish through 2022-3, as base effects fall out of the annual figures while consumers and sectors struggle with rising costs and supply chain bottlenecks.”

“This polarisation of the economy will also be evident across sectors. For example, we expect sectors like manufacturing to experience slower growth next year of between 1% and 2%, while hospitality is expected to grow between 16% and 20% under our ‘limited’ and ‘accelerated growth’ scenarios.”

“While many areas of the economy are returning to health and stability, this economic polarisation could create uneven effects and continue to act as a brake on growth in the medium term, even as some headwinds begin to clear.”

Three factors have the potential to pave the way for a consumer splurge next year: a strong labour market, combined with a large stock of excess savings, and a desire to move on from the pandemic could create the right recipe for household spending to propel growth.

Hoa Duong, Economist at PwC, said “More people have been going out to eat, going on holiday, and going to see their GP in person – and this normalisation of everyday activity is driving growth.”

“But the triple consumer splurge will likely be concentrated on higher income households, while lower income households could be hit by a triple consumer squeeze. There are three factors that have the potential to moderate this splurge, especially for lower income households. These households will feel the pinch from a combination of rising inflation, higher interest rates, and fiscal changes, especially the increase to national insurance contributions over 2022/23.”

Inflation could reach its highest level for three decades in Q2 2022 as the rise in the energy price cap and the reversal of the VAT cuts for hospitality and tourism create a perfect storm that is set to push headline inflation rates to around 5%-6%.

Jake Finney, Economist at PwC, said “We expect inflation to gradually fall back to target over the next 1-2 years as the impact of the rise in the energy price cap and reversal of VAT cuts reduce, recent supply bottlenecks ease, and base effects dissipate.”

“Yet there is a risk that higher inflation is sustained for longer if consumer inflation expectations become de-anchored from Bank of England’s own targets. This could become a self-reinforcing spiral as businesses set higher prices and workers demand higher wages, which will also negatively affect consumer spending.”

The short-term outlook for the labour market is cautiously optimistic. The emerging evidence points to a small overall impact of the end of the furlough scheme and the UK unemployment rate of 4.3% in September was only 0.3 percentage points higher than it was pre-COVID. A record 3.2% of workers also changed jobs in Q3 2021, which is a key sign of improving worker confidence, and there was 3.1% growth in average earnings in real terms until September 2021.

Hannah Audino, Economist at PwC, said “Most measures of labour market health are moving in the right direction, and there are signs of increasing tightness in the labour market as many workers return to work. However, it will take some months to understand the full impact of the end of furlough due to notice periods and there are signs of friction in matching workers to vacancies as businesses are increasingly reporting recruitment challenges.It is, however, likely that there will be a rise in the inactivity rate, as workers are discouraged from entering the workforce after so long out of work. It will therefore be important for government policy to shift its focus from the unemployed to the inactive, for example through retraining and reintegration programmes.”

Regional polarisation caused by the pandemic has been significantly more severe than any previous economic downturns, with the average regional disparity in Q2 2020 of 4.3 percentage points – more than double the nearest comparator of Q1 1974, the peak of the ‘winter of discontent.’

London and the North West are among those performing slightly worse than expected given their sectoral makeup. This is partly because of having a higher proportion of output coming from tourism and hospitality sectors, compared to other regions. The West Midlands, North East and South East also underperformed, of which the West Midlands was hit the hardest. It is mainly due to the regions being more reliant on manufacturing, retail and wholesale, which have been hammered by supply disruptions and social distancing restrictions.

Early indications are that Northern Ireland is the only region where economic growth has exceeded both expectations and the pre-crisis levels, while Scotland and Wales recorded an as-expected performance.

Gilham added “The pandemic has resulted in the most severe regional disparity in output in the past 50 years, and most UK regions underperformed expectations when it comes to the speed and scale of recovery,” says Jonathan Gillham. “This regional polarisation is one of the key drivers behind the UK’s sluggish recovery prospects, and may be one of the core factors affecting growth over the medium-to-long term.”