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Monday July 17, 2006 - 13:24:16 GMT
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Economics Weekly: Real earnings are the key to consumer recovery

Real earnings growth to boost consumer spending
Latest figures show that UK average earnings growth remains benign, rising by just 4.1% on an annual basis in May including bonuses and by 3.8% if bonuses are excluded. It is argued that this slow pace of earnings growth is what partly lies behind the even slower increase in consumer spending growth, which rose by just 0.3% in Q1 2006 or 1.5% on the year before in real terms. But our analysis suggests that it is real earnings growth that matters for consumer spending, not the nominal increase. We look at the recent pattern of real earnings growth to see what it tells us about the prospects for consumer spending growth recovering this year, the likely pace of economic growth and hence the implication for interest rates. The consensus view is that there will only be a modest increase in consumer spending this year and hence little pressure on interest rates from this source.

Earnings adjusted for inflation fit well with recovery in retail sales...
It is well known that consumer spending is driven by household confidence and by housing market turnover (via spending on household goods) but the importance of earnings growth can sometimes be overlooked. Recently, wage inflation appears to have slowed. To some, this puts at risk the prospects for economic recovery. But it is real earnings growth that matters not the nominal increase, as we show below, and here a rather brighter picture for consumer spending emerges. We have calculated real earnings growth by taking nominal growth in average earnings for the UK economy, including bonuses, and adjusted it to take account of consumer price inflation.

...since real earning growth is above the long run average, consumer spending should
approach its average too...

Chart a shows that real earnings growth is currently just above the long run average of 2%. But what is really interesting is that it was well below this figure in 2005, a period that coincided with weaker growth in gdp led by slower consumer spending. Overlaying real earnings growth with real economic growth shows a really good fit, see chart b. Indeed, this fit is better than comparing consumer spending growth with real personal disposable income growth for the same period, see chart c.

...and so real earnings growth should boost consumer spending more than expected this year...
If real earnings growth is compared with real increases in retail sales the conclusion that it drives retail spending growth is even plainer to see, see chart d. This refutes the conventional view that consumer spending growth will be held back by subdued wage inflation and rising utility bills, constraining growth in consumer spending to 2% or so in 2006. On the basis of our analysis, however, consumer spending growth this year could still average 2.5%, nearly a fifth higher due to still low price inflation and above average growth in real earnings. The implication is that consumer spending growth may seemingly suddenly accelerate later in the year to match the increase in real earnings growth. Increases in utility bills and rail and bus fare rises are damping spending growth but a rise in real earnings growth should help to limit the impact.

...but any rise in consumer spending will lead to calls for higher interest rates
The policy implication is that consumer spending growth may not remain a barrier for much longer to higher interest rates. Indeed, the link with real earnings growth would suggest that, if the fit holds true, consumer spending growth may be accelerating towards the third and fourth quarters of this year. The reason why consumer spending growth is perhaps below the pace indicated by real earnings growth is that household savings have risen, as consumers have been extra cautious about spending the gains in their real earnings due to worries about pensions, employment, etc. Based on the latest national accounts data, the UK’s household saving rate was 6% of disposable income in Q1 2006, up from just 4.1% in Q1 2005. This outcome implies that there is plenty of scope for consumer spending growth to accelerate in the UK over the year ahead. But faster consumer spending growth will renew concerns about the extent of spare capacity in the economy and likely lead to a rise in interest rates sooner than otherwise.


Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
Lloyds TSB Bank,
Financial Markets
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Faryners House,
25 Monument,
London EC3R 8BQ
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