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Low inflation ‘storing up problems for the future'

17 May 2016

London Street sign saying Pall Mall Responding to today’s inflation figures, which show the Consumer Prices Index dropped to 0.3% in the year to April, down from 0.5% in March, Michael Martins, Economist at the Institute of Directors, said:

“Although the upcoming EU referendum has caused depreciation of the pound, which traditionally puts upward pressure on inflation, it has also created considerable uncertainty, leading individuals and businesses to delay spending. Consumers are not buying big purchases, with sales of furniture and household appliances both falling, as they do not expect prices to rise anytime soon.

“As consumers hold off on purchases, businesses have begun to hold off on investment.  A combination of delayed consumer and business spending will continue to put downward pressure on inflation.

“Disposable income growth has been low in recent years. This mean means that, even though consumption has been declining, private debt continues to grow. Consumer credit card debt has increased by 5%. Low inflation makes paying off debt harder, so this is storing up problems for the future.

“There are also concerns about the affordability of mortgages, specifically those that have recently been taken on by younger professionals. If inflation remains low for a long time, and employers put off pay rises, the risk of mortgage and credit card default increases. This would a particular concern if the Bank of England was forced to raise interest rates rapidly in future.”

Explanatory notes

-          Inflation expectations are on a downward path:  inflation expectations in February 2016 fell to 1.8% compared to 2% in Q4 2015 and to 2.1% from 2.3% in Q4 2015 for next year, while core inflation fell to 1.2% from 1.5% the month previous.

-          Consumers have been holding off on consumption of higher priced consumer durables. Furniture fell by 2.5% compared to the month before although having grown by 1% on average over the past 10 months, major household appliances saw a fall of 2% after 6 months of continuous growth, and the purchases of new cars grew by 0.3% compared to an average growth rate of 1.6% over the previous 8 months.

-          Gross fixed capital formation fell 1.1% in Q4 2015, although this number will likely have fallen further, as this data comes from a period where we were aware that the referendum was likely to be held, but there was no official announcement on timing. Manufacturing is a better bellwether for the economy because its time horizons are longer and its sunk costs higher. This month saw output decrease by 1.9% compared to a year earlier, especially noteworthy given the 9% depreciation of the pound.

-          Disposable income growth, meanwhile has been low. increasing at a quarterly average rate of 1% over the past 8 years, while the savings rate is also low, in the area of 5%.

-          Two of the three main sectors of growth in employment are counter-cyclical sectors: restaurants and pubs and the creative industries have 4% more employees than last year. These sectors tend to be volatile, not particularly well paying, and have predominantly young staff. The other area of employment growth is in the ‘professional’ category where jobs tend to be higher paid. Young professionals are now buying houses for the first time: 72% of English buyers were in the fourth and fifth income quintiles, but importantly 61% of first-time buyers in 2014-2015 were between 25 and 34 years old.

-          Many chose 2 year fixed mortgages as fixed costs were lower compared to longer term mortgages, but were less risky compared to variable rate mortgages.  The proportion of fixed rate mortgages doubled between 2012 and 2015, and now make up above 80% of mortgages. As these mortgages transition from fixed to variable, if inflation remains lower for longer, firms hold off on pay rises as uncertainty builds (or continues after a possible vote to leave), and if there is a moment when the BoE must raise rates to guard against a current account run, this will put further downward pressure on inflation, growth, and increase the odds of widespread mortgage and credit card debt default.

-          At the same time, employment in ‘professional’ services comes in the most flexible and globally exposed area of the UK’s economy, so although employment is stable, this does not necessarily imply strength, but rather just a lack of downturn. The sectors that were hardest hit in the crisis were not barbers but financiers. This time is different; this time they have mortgages.

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