Households face biggest fall in real incomes on record

The Bank of England has warned that households will suffer the biggest income squeeze on record as soaring energy prices plunge the UK economy into a year-long recession.

Governor Andrew Bailey said families faced a "very big" shock to their finances as interest rates were raised to 1.75pc, the highest since 2008.

Its bleakest set of forecasts since the pandemic showed the Bank now expects inflation to hit a four-decade high of 13.3pc this year. It is also predicting the largest hit to real household incomes since records began in 1963, with a fall of 3.7pc across 2022 and 2023.

This is a bigger drop in living standards than during the financial crisis, the slump of the early 1990s or the stagflationary turmoil of the 1970s, even taking into account government help with energy bills.

A debate over how to tackle surging living costs has been at the heart of the Tory leadership contest. Frontrunner Liz Truss said she would use an emergency budget to help grow the economy as she called for "bold" reforms and tax cuts to boost growth.

But rival Rishi Sunak claimed that Ms Truss’s plan would “make everyone poorer”. He said: “Increasing borrowing will put upward pressure on interest rates, which will mean increased payments on people's mortgages."

The contenders on Thursday night clashed about the likelihood of recession and the best way to tackle the forecasted downturn and soaring inflation. 

Ms Truss said recession could be avoided: "What the Bank of England have said today is of course extremely worrying but it is not inevitable. We can change the outcome" 

She argued her tax cuts, including scrapping the Corporation Tax rise and reversing the National Insurance increase, would help avert the downturn, telling Sky News: “You simply cannot tax your way to growth.” 

But Mr Sunak, the former chancellor, insisted he would not promise tens of billions of pounds of “goodies” – a reference to his rival’s promises – because it would fuel inflation. 

He added: “We in the Conservative Party need to get real and fast because the lights on the economy are flashing red and the root cause is inflation.”

The economy is expected to shrink for five straight quarters starting at the end of this year, with higher unemployment and a slowdown in spending plunging the UK into the longest recession since the financial crisis.

This would leave the UK economy smaller than it was even before the global pandemic hit, with almost 900,000 more people out of work by the start of the next parliament in 2025.

The Bank's sixth rate rise in a row from 1.25pc is the biggest in 27 years, and comes as it warned that inflation was likely to remain in double-digits for another year. Consumer prices inflation stood at 9.4pc in June.

Higher interest rates help to tame inflation by raising the cost of borrowing across the economy. This encourages households and businesses to save more and spend less - helping to cool overall demand for goods and services.

Mr Bailey said it was right that the Bank was taking a more "forceful" approach to raising rates. He said ignoring high inflation in the face of a recession would only lead to faster and higher rate rises later.

"The alternative is even worse in terms of persistent inflation," he said.

The Bank cut its forecast for UK growth to 3.5pc this year, from 3.75pc in its previous forecast in May. The economy is expected to then shrink by 1.5pc in 2023 and 0.25pc in 2024

It expects real take-home pay to shrink for the next two years, even as companies offer higher salaries and one-off bonus payments to keep staff.

A typical worker earning £30,000 last year is projected to lose around £1,800 of annual spending power by the end of next year as their earnings do not stretch as far as they used to.

Mr Bailey also said the recent plunge in the value of the pound was “not a crisis” for now. Sterling has fallen about 15pc against the dollar over the past year.

The Bank warned the average household energy bill was likely to hit £3,500 this October amid a seven-fold increase in gas prices triggered by Russia’s war in Ukraine.

While inflation is expected to fall back toward the Bank’s 2pc target in a couple of years, policymakers said they were prepared to raise rates again “forcefully” if there were signs that price rises and wage increases were becoming entrenched.

A Bank poll of UK businesses showed families were already trading down to cheaper brands in their weekly supermarket shop. They were also now more likely to repair rather than replace broken items and put off trips to the dentist.

Nadhim Zahawi, the Chancellor, and Mr Bailey issued a joint statement on Thursday night pledging to "work to bear down on inflation, and the impact of rising prices on households".

Mr Zahawi was criticised alongside Prime Minister Boris Johnson for being on holiday while the Bank released its dire economic outlook. Mr Zahawi said he was "working remotely" on a family holiday. The Chancellor said: “There is no such thing as a holiday and not working. I never had that in the private sector, nor in government. Ask any entrepreneur and they can tell you that.”

The four key drivers of the cost of living crisis

By Tim Wallace

Speaking on Thursday, Andrew Bailey, the Bank’s Governor, placed much of the blame for the spike in prices squarely at the Kremlin’s door.

“The Russian shock is now the largest contributor to UK inflation by some way,” he said.

But it is not the only factor.

Here are the four key drivers of the cost of living crisis:

Energy prices

Household energy bills were rising rapidly before the invasion, but Russia’s decision to attack Ukraine sent prices into overdrive.

In recent months, Moscow’s threats to withhold gas supplies from Europe have raised the pressure still further.

Mr Bailey said prices for gas delivery at the end of this year are seven times higher than the market forecast last year “overwhelmingly as a result of Russia’s restriction of gas supplies to Europe and the risk of further curbs".

The result is a massive rise in the energy price cap in October. The Bank expects a 75pc jump. 

“That would increase the typical annual dual-fuel bill from just under £2,000 to around £3,500 in October,” said the minutes of the MPC’s report.

Ben Broadbent, Mr Bailey’s deputy, compared the situation to the energy price shocks of the 1970s. The impact on household budgets will be five times as large as that shock five decades ago.

“Over the worst two-year period of the 70s, between the first quarters of 1974 and 1976, the share of income going on household utility bills rose by 0.7 percentage points, so it absorbed that much of real income growth over the period,” he said.

“Between the first quarter of 2021 and 2023, we think that number will be pretty much 3.5 percentage points, it is around five-times as big.”

Food prices

Food costs have also spiked as a result of war, as Russia and Ukraine are both major grain producers.

“The food situation was very serious and remains very serious,” said Mr Bailey, noting that the jump in cost of essentials is particularly damaging for families on low incomes.

There might be some reasons to hope that increases in these prices may slow down soon, unlike energy.

“Food commodity prices have on balance come down over the past few months,” the Governor said.

“It reflects the fact that there has been quite good news on crop yields in other parts of the world. We are all hoping the ship that left Odessa this week will be the first of many and will provide much-needed relief.”

Supply chains

Inflation was a problem before the war in Ukraine and much of the pre-Ukraine price rises came from chaos in global supply chains.

Covid disrupted factories, ports and shipping routes and sent demand for physical goods spiking as locked-down families had no chance to spend their money on going out and looked for entertainment.

Some of this is continuing. Regular lockdowns in China persist due to the world’s second-largest economy’s continuing “zero covid” strategy. This is disrupting production at factories there. 

The Bank of England said there were “some early signs that supply bottlenecks had started to ease,” but that “constraints had remained elevated.”

“Some indicators of shipping costs had declined from their peaks, while PMI surveys indicated that manufacturing delivery times had fallen back across different regions.”

Mr Bailey said the “series of supply shocks” from Covid and the war have had a cumulative impact: the world economy struggles to recover from one before another strikes.

“There have been no air gaps between these shocks. If you think about the covid supply chain shock, which we now begin to see evidence in terms of traded goods prices of it beginning to come off, that has been replaced by this huge shock we are receiving in terms of energy prices, emanating from the actions Russia is taking,” he said.

Pay and price rises

Wave after wave of global shocks is taking its toll on businesses, which are pushing through price rises.

As a result, workers aer seeking higher pay. This can protect them against inflation, but also threatens to embed price rises throughout the economy. Higher wages tend to drive higher prices, risking a much-feared wage-price spiral.

“There have been some indications that inflationary pressures are becoming more persistent and broadening to more domestically driven sectors,” said the MPC in its minutes.

“Companies are finding it easier to increase prices, and the labour market remains tight. In such an environment, there is a risk that the further jump in energy prices, and the higher and more protracted path for CPI inflation over the next 18 months, will lead to more enduring domestic price and wage pressures.”

This is the underlying threat against which the Bank is acting with its sharp rise in interest rates.

“If we don’t act, inflation will become more embedded, it will become worse and we will have to raise interest rates by more,” said Mr Bailey.