A crucial determinant of the economy’s short-term prospects is the appetite of households for spending. This is because household spending makes up roughly two-thirds of the total demand for firms’ goods and services or two-thirds of what economists refer to as aggregate demand. So what are the latest forecasts for consumer spending? We briefly consider the forecasts of the Office for Budget Responsibility for consumer spending and, in doing so, update an earlier bog Gloomy prospects for spending in 2012?
The OBR are forecasting that household spending will increase in real terms in 2012 by 0.5 per cent and by a further 1.3 per cent in 2013. This is on the back of a fall in real consumption in 2011 of 1.2 per cent. Therefore, the rebound in consumer spending is predicted to be only fairly modest. The long-term average annual real increase in household spending is around 2½ per cent.
The drag on consumer spending growth remains the weakness of growth in real disposable income. The post-tax income of the household sector fell in real terms by 1.2 per cent in 2011 and is expected to fall by a further 0.2 per cent in 2012. It is not until 2015 that growth in real disposable income returns to its long-term average which, unsurprisingly, is roughly the same as that of household sector spending.
As we noted in our earlier blog, the OBR’s short-term figures on spending growth critically depend on the ability of households to absorb the negative shocks to their real income. Empirical evidence tends to show that household spending growth is less variable than that in income and that households try and smooth, if they can, their spending. Therefore, the marginal propensity of households to consume out of changes in their income is below 1 in the short-run. This is consistent with the idea that households are consumption-smoothers disliking excessively volatile spending patterns.
The actual figures for consumption and income growth in 2011 help to show that consumption-smoothing cannot be taken for granted. In 2011, the fall in consumption exactly matched that in income. An important impediment to consumption-smoothing in recent times has been the impact of the financial crisis on bank lending. Banks have become more cautious in their lending and so households have been less able to borrow to support their spending in the face of falling real incomes. Another impediment to consumption-smoothing is likely to be the continuing unease amongst households to borrow (assuming they can) or to draw too heavily on their savings. In uncertain times, households may feel the need for a larger buffer stock of wealth to act as a security blanket.
In short, the latest OBR figures suggest that the growth in consumption in the medium-term will remain relatively weak. Retailers are likely to ‘feel the pinch’ for some time to come.
Compare the consumption forecasts produced by the Office for Budget Responsibility in March 2012 with those it produced in November 2011. To see the earlier forecasts go to Gloomy prospects for spending in 2012?
What do you understand by a consumption function? What variables would you include in such a function?
Using the figures in the table in the text above, calculate ‘rough’ estimates of the income elasticity of consumption for each year. Why are these estimates only ‘rough’ approximations of the income elasticity of consumer spending?
Draw up a list of factors that are likely to affect the strength of consumer spending in 2012. Explain how similar or different these factors are likely to have been to those that may affect spending during periods of strong economic growth.
Explain what you understand by the term consumption-smoothing. Explore how households can smooth their spending and the factors that are likely to both help and prevent them from doing so.
What do you understand by the net worth of households? Try drawing up a list of factors that could affect the net worth of households and then analyse how they might affect consumer spending.