Author: Dean Garratt

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The approach to monetary and fiscal policy

The following blog is inspired by my teaching of macroeconomic issues to my final year students at Aston University. In the classes we’ve been discussing important aspects of monetary and fiscal policy design. What has become clear to me and my students is that the trade-offs which characterise the discipline of economics are certainly alive and well in the current environment in which monetary and fiscal policy choices are being made.

To demonstrate this we consider here some of the discussions we’ve had in class around central bank independence and monetary policy mandates. We’ve also looked at fiscal policy. Here we’ve examined the state of the public finances and the importance that seems to be attached to debt stabilisation and the imposition of debt rules.

Delegation and central bank mandates

My teaching this term began by introducing my students to one of the most important and influential monetary policy models. This is the model of Kydland and Prescott. Their model, published in the Journal of Political Economy in 1977 has become the theoretical bedrock for the modern-day operational independence of central banks.1

The model explores how systemically high inflation can become established in economies when policymakers have the political incentive to lower unemployment or increase output above its long-run equilibrium value. This may be the case if governments operate monetary policy rather than the central bank (of if the central bank operates monetary policy but follows government objectives). By adopting expansionary monetary policy, governments can increase their popularity.

But this is likely to be short-lived, as any increased economic activity will only be temporary (assuming that the natural-rate hypothesis holds). Soon, inflation will rise.

But, if an election is on the horizon, there may be enough time to boost output and employment before inflation rises. In other words, an expectations-augmented Phillips curve may present governments with an incentive to loosen monetary policy and worry about the inflation consequences after the election.

However, the resulting ‘inflation surprise’ through the loosening of monetary policy means a fall in real pay and therefore in purchasing power. If people suspect that governments will be tempted to loosen policy, they will keep their expectations of inflation higher than the socially optimal inflation rate. Consequently, low-inflation targets lack credibility when governments have the temptation to loosen monetary policy. Such targets are time-inconsistent because governments have an incentive to renege and deliver higher inflation through a looser monetary policy. The result is an inflation bias.

Central bank independence
To prevent this inflationary bias arising, many central banks around the world have been given some form of operational independence with a mandate centred around an inflation-rate target. By delegating monetary policy to a more conservative central bank, the problem of inflationary bias can be addressed.

Yet central bank independence is not without its own issues and this has been an important part of the discussions with my students. Today, many economies are continuing to experience the effects of the inflationary shocks that began in 2021 (see Chart 1 for the UK CPI inflation rate: click here for a PowerPoint). The question is whether the appointment of a conservative or hard-nosed hawkish central banker trades off the stabilisation of inflation for greater volatility in output or unemployment.

The inflation–output stabilisation trade-off is closely associated with the works of Kenneth Rogoff2 and John Taylor3. The latter is known for his monetary policy rule, which has become known as the ‘Taylor rule’. This advocates that a rules-based central bank ought to place weight on both inflation and output stabilisation.

This is not without its own issues, however, since, by also placing weight on output stabilisation, we are again introducing the possibility of greater inflationary bias in policy making. Hence, while the act of delegation and a rules- or target-based approach may mitigate the extent of the bias relative to that in the Kydland and Prescott model, there nonetheless still remain issues around the design of the optimal framework for the conduct of monetary policy.

Indeed, the announcement that the UK had moved into recession in the last two quarters of 2023 can be seen as evidence that an otherwise abstract theoretical trade-off between inflation and output stabilisation is actually very real.

My classroom discussions have also shown how economic theory struggles to identify an optimal inflation-rate target. Beyond accepting that a low and stable inflation rate is desirable, it is difficult to address fully the student who asks what is so special about a 2% inflation target. Would not a 3% target, for example, be preferable, they might ask?

Whilst this may sound somewhat trivial, it has real-world consequences. In a world that now seems to be characterised by greater supply-side volatility and by more frequent inflation shocks than we were used to in recent history, might a higher inflation rate target be preferable? Certainly, one could argue that, with an inflation–output stabilisation trade-off, there is the possibility that monetary policy could be unduly restrictive in our potential new macroeconomic reality. Hence, we might come to see governments and central banks in the near future revisiting the mandates that frame the operation of their monetary policy. Time will tell.

Fiscal policy and debt stabilisation

The second topic area that I have been discussing in my final-year macroeconomics classes has centred around fiscal policy and the state of the public finances. The context for this is that we have seen a significant increase in public debt-to-GDP ratios over the past couple of decades as the public sector has attempted to absorb significant economic shocks. These include the global financial crisis of 2007–8, the COVID-19 pandemic and the cost-of-living crisis. These interventions in the case of the UK have seen its public debt-to-GDP ratio more than triple since the early 2000s to close to 100% (see Chart 2: click here for a PowerPoint).

Understandably, given the stresses placed on the public finances, economists have increasingly debated issues around debt sustainability. These debates have been mirrored by politicians and policymakers. A key question is whether to have a public debt rule. The UK has in recent years adopted such a rule. The arguments for a rule centre on ensuring sound public finances and maintaining the confidence of investors to purchases public debt. A debt rule therefore places a discipline on fiscal policy, with implications for taxation and spending.

How easy it is to stick to a debt rule depends on three key factors. It will be harder to stick to the rule:

  • The higher the current debt-to-GDP ratio and hence the more it needs to be reduced to meet the rule.
  • The higher the rate of interest and hence the greater the cost of servicing the public debt.
  • The lower the rate of economic growth and hence the less quickly will tax revenues rise.

With a given debt-to-GDP ratio, a given average interest rate payable on its debt, and a given rate of economic growth, we can determine the primary fiscal balance relative to GDP a government would need to meet for the debt-to-GDP ratio to remain stable. This is known as the ‘debt-stabilising primary balance’. The primary balance is the difference between a government’s receipts and its expenditures less the interest payments on its debt.

This fiscal arithmetic is important in determining a government’s fiscal choices. It shows the implications for spending and taxation. These implications become ever more important and impactful on people, businesses, and society when the fiscal arithmetic becomes less favourable. This is a situation that appears to be increasingly the case for many countries, including the UK, as the rate of interest on public debt rises relative to a country’s rate of economic growth. As this happens, governments are increasingly required to run healthier primary balances. This of course implies a tightening of their fiscal stance.

Hence, the fiscal conversations with my students have focused on both the benefits and the costs of debt-stabilisation. In respect of the costs, a few issues have arisen.

First, as with the inflation-rate target, it is hard to identify an optimal public debt-to-GDP ratio number. While the fiscal arithmetic may offer some clue, it is not straightforward to address the question as to whether a debt-to-GDP ratio of say 100% or 120% would be excessive for the UK.

Second, it is possible that the debt stabilisation itself can make the fiscal arithmetic of debt stabilisation more difficult. This occurs if fiscal consolidation itself hinders long-term economic growth, which then makes the fiscal arithmetic more difficult. This again points to the difficulties in designing policy frameworks, whether they be for monetary or fiscal policy.

Third, a focus on debt stabilisation alone ignores the fact that there are two sides to any sector’s balance sheet. It would be very unusual when assessing the well-being of businesses or households if we were to ignore the asset side of their balance sheet. Yet, this is precisely the danger of focusing on public debt at the exclusion of what fiscal choices can mean for public-sector assets, from which we all can potentially benefit. Hence, some would suggest a more balanced approach to assessing the soundness of the public finances might involve a net worth (assets less liabilities) measure. This has parallels with the debates around whether mandates of central banks should be broader.

Applications in macroeconomics

What my teaching of a topics-based macroeconomics module this term has vividly demonstrated is that concepts, theories, and models come alive, and are capable of being understood better, when they are used to shine a light on real-world issues. The light being shone on monetary and fiscal policy in today’s turbulent macroeconomic environment is perhaps understandably very bright.

Indeed, the light being shone on fiscal policy in the UK and some other countries facing an upcoming election, is intensified further with the state of the public finances shaping much of the public discourse on fiscal choices. Hopefully, my students will continue to debate these important issues beyond their graduation, stressing their importance for people’s lives and, in doing so, going beyond the abstract.

References

  1. Rules rather than discretion: The inconsistency of optimal plans
    The Journal of Political Economy, Finn E Kydland and Edward C. Prescott (1977, 85(3), pp 473–92)

  2. The optimal degree of commitment to an intermediate monetary target
    Quarterly Journal of Economics, Kenneth Rogoff (November 1985, 100(4), pp 1169–89)

  3. Discretion versus policy rules in practice
    Carnegie-Rochester Conference Series on Public Policy, John B Taylor (December 1993, 39, pp 195–214)

Articles

Questions

  1. What is meant by time-inconsistent monetary policy announcements? How has this concept been important for the way in which many central banks now conduct monetary policy?
  2. What is meant by a ‘conservative’ central banker? Why is the appointment of this type of central banker thought to be important in affecting inflation?
  3. What is the contemporary macroeconomic relevance of the inflation–output (or inflation–unemployment) stabilisation trade-off?
  4. How is the primary balance different from the actual budget balance?
  5. What do you understand by the concept of ‘the fiscal arithmetic’. Explain how each element of the fiscal arithmetic affects the debt-stabilising primary balance?
  6. Analyse the costs of benefits of a debt-based fiscal rule.
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The fiscal arithmetic of sustainable public debt: is the maths getting harder?

The past decade or so has seen large-scale economic turbulence. As we saw in the blog Fiscal impulses, governments have responded with large fiscal interventions. The COVID-19 pandemic, for example, led to a positive fiscal impulse in the UK in 2020, as measured by the change in the structural primary balance, of over 12 per cent of national income.

The scale of these interventions has led to a significant increase in the public-sector debt-to-GDP ratio in many countries. The recent interest rates hikes arising from central banks responding to inflationary pressures have put additional pressure on the financial well-being of governments, not least on the financing of their debt. Here we discuss these pressures in the context of the ‘r – g’ rule of sustainable public debt.

Public-sector debt and borrowing

Chart 1 shows the path of UK public-sector net debt and net borrowing, as percentages of GDP, since 1990. Debt is a stock concept and is the result of accumulated flows of past borrowing. Net debt is simply gross debt less liquid financial assets, which mainly consist of foreign exchange reserves and cash deposits. Net borrowing is the headline measure of the sector’s deficit and is based on when expenditures and receipts (largely taxation) are recorded rather than when cash is actually paid or received. (Click here for a PowerPoint of Chart 1)

Chart 1 shows the impact of the fiscal interventions associated with the global financial crisis and the COVID-19 pandemic, when net borrowing rose to 10 per cent and 15 per cent of GDP respectively. The former contributed to the debt-to-GDP ratio rising from 35.6 per cent in 2007/8 to 81.6 per cent in 2014/15, while the pandemic and subsequent cost-of-living interventions contributed to the ratio rising from 85.2 per cent in 2019/20 to around 98 per cent in 2023/24.

Sustainability of the public finances

The ratcheting up of debt levels affects debt servicing costs and hence the budgetary position of government. Yet the recent increases in interest rates also raise the costs faced by governments in financing future deficits or refinancing existing debts that are due to mature. In addition, a continuation of the low economic growth that has beset the UK economy since the global financial crisis also has implications for the burden imposed on the public sector by its debts, and hence the sustainability of the public finances. After all, low growth has implications for spending commitments, and, of course, the flow of receipts.

The analysis therefore implies that the sustainability of public-sector debt is dependent on at least three factors: existing debt levels, the implied average interest rate facing the public sector on its debts, and the rate of economic growth. These three factors turn out to underpin a well-known rule relating to the fiscal arithmetic of public-sector debt. The rule is sometimes known as the ‘r – g’ rule (i.e. the interest rate minus the growth rate).

Underpinning the fiscal arithmetic that determines the path of public-sector debt is the concept of the ‘primary balance’. This is the difference between the sector’s receipts and its expenditures less its debt interest payments. A primary surplus (a positive primary balance) means that receipts exceed expenditures less debt interest payments, whereas a primary deficit (a negative primary balance) means that receipts fall short. The fiscal arithmetic necessary to prevent the debt-to-GDP ratio rising produces the following stable debt equation or ‘r – g’ rule:

On the left-hand side of the stable debt equation is the required primary surplus (PS) to GDP (Y) ratio. Moving to the right-hand side, the first term is the existing debt-to-GDP ratio (D/Y). The second term ‘r – g’, is the differential between the average implied interest rate the government pays on its debt and the growth rate of the economy. These terms can be expressed in either nominal or real terms as this does not affect the differential.

To illustrate the rule consider a country whose existing debt-to-GDP ratio is 1 (i.e. 100 per cent) and the ‘r – g’ differential is 0.02 (2 percentage points). In this scenario they would need to run a primary surplus to GDP ratio of 0.02 (i.e. 2 percent of GDP).

The ‘r – g‘ differential

The ‘r – g’ differential reflects macroeconomic and financial conditions. The fiscal arithmetic shows that these are important for the dynamics of public-sector debt. The fiscal arithmetic is straightforward when r = g as any primary deficit will cause the debt-to-GDP ratio to rise, while a primary surplus will cause the ratio to fall. The larger is g relative to r the more favourable are the conditions for the path of debt. Importantly, if the differential is negative (r < g), it is possible for the public sector to run a primary deficit, up to the amount that the stable debt equation permits.

Consider Charts 2 and 3 to understand how the ‘r – g’ differential has affected debt sustainability in the UK since 1990. Chart 2 plots the implied yield on 10-year government bonds, alongside the annual rate of nominal growth (click here for a PowerPoint). As John explains in his blog The bond roller coaster, the yield is calculated as the coupon rate that would have to be paid for the market price of a bond to equal its face value. Over the period, the average annual nominal growth rate was 4.5 per cent, while the implied interest rate was almost identical at 4.6 per cent. The average annual rate of CPI inflation over this period was 2.8 per cent.

Chart 3 plots the ‘r – g’ differential which is simply the difference between the two series in Chart 2, along with a 12-month rolling average of the differential to help show better the direction of the differential by smoothing out some of the short-term volatility (click here for a PowerPoint). The differential across the period is a mere 0.1 percentage points implying that macroeconomic and financial conditions have typically been neutral in supporting debt sustainability. However, this does mask some significant changes across the period.

We observe a general downward trend in the ‘r – g’ differential from 1990 up to the time of the global financial crisis. Indeed between 2003 and 2007 we observe a favourable negative differential which helps to support the sustainability of public debt and therefore the well-being of the public finances. This downward trend of the ‘r – g’ differential was interrupted by the financial crisis, driven by a significant contraction in economic activity. This led to a positive spike in the differential of over 7 percentage points.

Yet the negative differential resumed in 2010 and continued up to the pandemic. Again, this is indicative of the macroeconomic and financial environments being supportive of the public finances. It was, however, largely driven by low interest rates rather than by economic growth.

Consequently, the negative ‘r – g’ differential meant that the public sector could continue to run primary deficits during the 2010s, despite the now much higher debt-to-GDP ratio. Yet, weak growth was placing limits on this. Chart 4 indeed shows that primary deficits fell across the decade (click here for a PowerPoint).

The pandemic and beyond

The pandemic saw the ‘r – g’ differential again turn markedly positive, averaging 7 percentage points in the four quarters from Q2 of 2020. While the differential again turned negative, the debt-to-GDP ratio had also increased substantially because of large-scale fiscal interventions. This made the negative differential even more important for the sustainability of the public finances. The question is how long the negative differential can last.

Looking forward, the fiscal arithmetic is indeed uncertain and worryingly is likely to be less favourable. Interest rates have risen and, although inflationary pressures may be easing somewhat, interest rates are likely to remain much higher than during the past decade. Geopolitical tensions and global fragmentation pose future inflationary concerns and a further drag on growth.

As well as the short-term concerns over growth, there remain long-standing issues of low productivity which must be tackled if the growth of the UK economy’s potential output is to be raised. These concerns all point to the important ‘r – g’ differential become increasingly less negative, if not positive. If so the fiscal arithmetic could mean increasingly hard maths for policymakers.

Articles

Data

Questions

  1. What is meant by each of the following terms: (a) net borrowing; (b) primary deficit; (c) net debt?
  2. Explain how the following affect the path of the public-sector debt-to-GDP ratio: (a) interest rates; (b) economic growth; (c) the existing debt-to-GDP ratio.
  3. Which factors during the 2010s were affecting the fiscal arithmetic of public debt positively, and which negatively?
  4. Discuss the prospects for the fiscal arithmetic of public debt in the coming years.
  5. Assume that a country has an existing public-sector debt-to-GDP ratio of 60 percent.
    (a) Using the ‘rule of thumb’ for public debt dynamics, calculate the approximate primary balance it would need to run in the coming year if the expected average real interest rate on the debt were 3 per cent and real economic growth were 2 per cent?
    (b) Repeat (a) but now assume that real economic growth is expected to be 4 per cent.
    (c) Repeat (a) but now assume that the existing public-sector debt-to-GDP ratio is 120 per cent.
    (d) Using your results from (a) to (c) discuss the factors that affect the fiscal arithmetic of the growth of public-sector debt.
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Fiscal impulses

In his blog, The bond roller coaster, John looks at the pricing of government bonds and details how, in recent times, governments wishing to borrow by issuing new bonds are having to offer higher coupon rates to attract investors. The interest rate hikes by central banks in response to global-wide inflationary pressures have therefore spilt over into bond markets. Though this evidences the ‘pass through’ of central bank interest rate increases to the general structure of interest rates, it does, however, pose significant costs for governments as they seek to finance future budgetary deficits or refinance existing debts coming up to maturity.

The Autumn Statement in the UK is scheduled to be made on 22 November. This, as well as providing an update on the economy and the public finances, is likely to include a number of fiscal proposals. It is thus timely to remind ourselves of the size of recent discretionary fiscal measures and their potential impact on the sustainability of the public finances. In this first of two blogs, we consider the former: the magnitude of recent discretionary fiscal policy changes.

First, it is important to define what we mean by discretionary fiscal policy. It refers to deliberate changes in government spending or taxation. This needs to be distinguished from the concept of automatic stabilisers, which relate to those parts of government budgets that automatically result in an increase (decrease) of spending or a decrease (increase) in tax payments when the economy slows (quickens).

The suitability of discretionary fiscal policy measures depends on the objectives they trying to fulfil. Discretionary measures can be implemented, for example, to affect levels of public-service provision, the distribution of income, levels of aggregate demand or to affect longer-term growth of aggregate supply. As we shall see in this blog, some of the large recent interventions have been conducted primarily to support and stabilise economic activity in the face of heightened economic volatility.

Discretionary fiscal measures in the UK are usually announced in annual Budget statements in the House of Commons. These are normally in March, but discretionary fiscal changes can be made in the Autumn Statement too. The Autumn Statement of October 2022, for example, took on significant importance as the new Chancellor of the Exchequer, Jeremy Hunt, tried to present a ‘safe pair hands’ following the fallout and market turbulence in response to the fiscal statement by the former Chancellor, Kwasi Kwarteng, on 23 September that year.

The fiscal impulse

The large-scale economic turbulence of recent years associated first with the global financial crisis of 2007–9 and then with the COVID-19 pandemic and the cost-of-living crisis, has seen governments respond with significant discretionary fiscal measures. During the COVID-19 pandemic, examples of fiscal interventions in the UK included the COVID-19 Business Interruption Loan Scheme (CBILS), grants for retail, hospitality and leisure businesses, the COVID-19 Job Retention Scheme (better known as the furlough scheme) and the Self-Employed Income Support Scheme.

The size of discretionary fiscal interventions can be measured by the fiscal impulse. This captures the magnitude of change in discretionary fiscal policy and thus the size of the stimulus. The concept is not to be confused with fiscal multipliers, which measure the impact of fiscal changes on economic outcomes, such as real national income and employment.

By measuring fiscal impulses, we can analyse the extent to which a country’s fiscal stance has tightened, loosened, or remained unchanged. In other words, we are attempting to capture discretionary fiscal policy changes that result in structural changes in the government budget and, therefore, in structural changes in spending and/or taxation.

To measure structural changes in the public-sector’s budgetary position, we calculate changes in structural budget balances.

A budget balance is simply the difference between receipts (largely taxation) and spending. A budget surplus occurs when receipts are greater than spending, while a deficit (sometimes referred to as net borrowing) occurs if spending is greater than receipts.

A structural budget balance cyclically-adjusts receipts and spending and hence adjusts for the position of the economy in the business cycle. In doing so, it has the effect of adjusting both receipts and spending for the effect of automatic stabilisers. Another way of thinking about this is to ask what the balance between receipts and spending would be if the economy were operating at its potential output. A deterioration in a structural budget balance infers a rise in the structural deficit or fall in the structural surplus. This indicates a loosening of the fiscal stance. An improvement in the structural budget balance, by contrast, indicates a tightening.

The size of UK fiscal impulses

A frequently-used measure of the fiscal impulse involves the change in the cyclically-adjusted public-sector primary deficit.

A primary deficit captures the extent to which the receipts of the public sector fall short of its spending, excluding its spending on debt interest payments. It essentially captures whether the public sector is able to afford its ‘new’ fiscal choices from its receipts; it excludes debt-servicing costs, which can be thought of as reflecting fiscal choices of the past. By using a cyclically-adjusted primary deficit we are able to isolate more accurately the size of discretionary policy changes. Chart 1 shows the UK’s actual and cyclically-adjusted primary deficit as a share of GDP since 1975, which have averaged 1.3 and 1.1 per cent of GDP respectively. (Click here for a PowerPoint of the chart.)

The size of the fiscal impulse is measured by the year-on-year percentage point change in the cyclically-adjusted public-sector primary deficit as a percentage of potential GDP. A larger deficit or a smaller surplus indicates a fiscal loosening (a positive fiscal impulse), while a smaller deficit or a larger surplus indicates a fiscal tightening (a negative fiscal impulse).

Chart 2 shows the magnitude of UK fiscal impulses since 1980. It captures very starkly the extent of the loosening of the fiscal stance in 2020 in response to the COVID-19 pandemic. (Click here for a PowerPoint of the chart.) In 2020 the cyclically-adjusted primary deficit to potential output ratio rose from 1.67 to 14.04 per cent. This represents a positive fiscal impulse of 12.4 per cent of GDP.

A tightening of fiscal policy followed the waning of the pandemic. 2021 saw a negative fiscal impulse of 10.1 per cent of GDP. Subsequent tightening was tempered by policy measures to limit the impact on the private sector of the cost-of-living crisis, including the Energy Price Guarantee and Energy Bills Support Scheme.

In comparison, the fiscal response to the global financial crisis led to a cumulative increase in the cyclically-adjusted primary deficit to potential GDP ratio from 2007 to 2009 of 5.0 percentage points. Hence, the financial crisis saw a positive fiscal impulse of 5 per cent of GDP. While smaller in comparison to the discretionary fiscal responses to the COVID-19 pandemic, it was, nonetheless, a sizeable loosening of the fiscal stance.

Sustainability and well-being of the public finances

The recent fiscal interventions have implications for the financial well-being of the public-sector. Not least, the financing of the positive fiscal impulses has led to a substantial growth in the accumulated size of the public-sector debt stock. At the end of 2006/7 the public-sector net debt stock was 35 per cent of GDP; at the end of the current financial year, 2023/24, it is expected to be 103 per cent.

As we saw at the outset, in an environment of rising interest rates, the increase in the public-sector debt to GDP ratio creates significant additional costs for government, a situation that is made more difficult for government not only by the current flatlining of economic activity, but by the low underlying rate of economic growth seen since the financial crisis. The combination of higher interest rates and lower economic growth has adverse implications for the sustainability of the public finances and the ability of the public sector to absorb the effects of future economic crises.

Articles

Report

  • IFS Green Budget

    • Institute for Fiscal Studies, Carl Emmerson, Paul Johnson and Ben Zaranko (eds) (October 2023)

Data

Questions

  1. Explain what is meant by the following fiscal terms: (a) structural deficit; (b) automatic stabilisers; (c) discretionary fiscal policy; (d) primary deficit.
  2. What is the difference between current and capital public expenditures? Give some examples of each.
  3. Consider the following two examples of public expenditure: grants from government paid to the private sector for the installation of energy-efficient boilers, and welfare payments to unemployed people. How are these expenditures classified in the public finances and what fiscal objectives do you think they meet?
  4. Which of the following statements about the primary balance is FALSE?
    (a) In the presence of debt interest payments a primary deficit will be smaller than a budget deficit.
    (b) In the presence of debt interest payments a primary surplus will be smaller than a budget surplus.
    (c) The primary balance differs from the budget balance by the size of debt interest payments.
    (d) None of the above.
  5. Explain the difference between a fiscal impulse and a fiscal multiplier.
  6. Why is low economic growth likely to affect the sustainability of the public finances? What other factors could also matter?
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Nominal and real retail sales figures: interpreting the data

The distinction between nominal and real values in one of the ‘threshold concepts’ in economics. These are concepts that are fundamental to a discipline and which occur again and again. The distinction between nominal and real values is particularly important when interpreting and analysing data. We show its importance here when analysing the latest retail sales data from the Office for National Statistics.

Retail sales relate to spending on items such as food, clothing, footwear, and household goods (see). They involve sales by retailers directly to end consumers whether in store or online. The retail sales index for Great Britain is based on a monthly survey of around 5000 retailers across England, Scotland and Wales and is thought to capture around 93 per cent of turnover in the sector.

Estimates of retail sales are published in index form. There are two indices published by the ONS: a value and volume measure. The value index reflects the total turnover of business, while the volume index adjusts the value index for price changes. Hence, the value estimates are nominal, while the volume estimates are real. The key point here is that the nominal estimates reflect both price and volume changes, whereas the real estimates adjust for price movements to capture only volume changes.

The headline ONS figures for September 2023 showed a 0.9 per cent volume fall in the volume of retail sales, following a 0.4 per cent rise in August. In value terms, September saw a 0.2 per cent fall in retail sales following a 0.9 per cent rise in August. Monthly changes can be quite volatile, even after seasonal adjustment, and sensitive to peculiar factors. For example, the unusually warm weather this September helped to depress expenditure on clothes. It is, therefore, sensible to take a longer-term view when looking for clearer patterns in spending behaviour.

Chart 1 plots the value and volume of retail sales in Great Britain since 1996. (Click here for a PowerPoint of this and the other two charts). In value terms, retail sales spending increased by 165 per cent, whereas in volume terms, spending increased by 73 per cent. This difference is expected in the presence of rising prices, since nominal growth, as we have just noted, reflects both price and volume changes. The chart is notable for capturing two periods where the volume of retail spending ceased to grow. The first of these is following the global financial crisis of the late 2000s. The period from 2008 to 2013 saw the volume of retail sales stagnate and flatline with a recovery in volumes only really starting to take hold in 2014. Yet in nominal terms retail sales grew by around 16 per cent.

The second of the two periods is the decline in the volume of retail sales from 2021. To help illustrate this more clearly, Chart 2 zooms in on retail sales over the past five years or so. We can see a significant divergence between the volume and value of retail sales. Between April 2021 and September 2023, the volume of retail sales fell by 11%. In contrast, the value of retail sales increased by 8.4%. The impact of the inflationary shock and the consequent cost-of-living crisis that emerged from 2021 is therefore demonstrated starkly by the chart, not least the severe drag that it has had on the volume of retail spending. This has meant that the aggregate volume of retail sales in September 2023 was only back to the levels of mid-2018.

Finally, Chart 3 shows the patterns in the volumes of retailing by four categories since 2018: specifically, food stores, predominantly non-food stores, non-store retail, and automotive fuel. The largest fall in the volume of retail sales has been experienced by non-store retailing – largely online retailing. From its peak in December 2021, non-store retail sales decreased by 18% up to September 2023. While this needs to be set in the context of the volume of non-store retail purchases being 15% higher than in February 2020 before the pandemic lockdowns were introduced, it is nonetheless indicative of the pressures facing online retailers.

Importantly, the final chart shows that the pressures in retailing are widespread. Spending volumes on automotive fuels, and in food and non-food stores are all below 2019 levels. The likelihood is that these pressures will persist for some time to come. This inevitably has potential implications for retailers and, of course, for those that work in the sector.

Articles

Statistical bulletin

Data

Questions

  1. Why does an increase in the value of retail sales not necessarily mean that their volume has increased?
  2. In the presence of deflation, which will be higher: nominal or real growth rates?
  3. Discuss the factors that could explain the patterns in the volume of spending observed in the different categories of retail sales in Chart 3.
  4. Discuss what types of retail products might be more or less sensitive to the macroeconomic environment.
  5. Conduct a survey of recent media reports to prepare a briefing discussing examples of retailers who have struggled or thrived in the recent economic environment.
  6. What do you understand by the concepts of ‘consumer confidence’ and ‘economic uncertainty’? How might these affect the volume of retail spending?
  7. Discuss the proposition that the retail sales data cast doubt on whether people are ‘forward-looking consumption smoothers’.
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Inflation and household balance sheets

This is the second of three blogs looking at high inflation and its implications. Here we look at changes in the housing market and its effects on households. Another way of analysing the financial importance of the housing and mortgage markets is through the balance sheets and associated flow accounts of the household sector.

We used the concept of balance sheets in our blog Bank failures and the importance of balance sheets. In the blog we referred to the balance-sheet effects from interest rate hikes on the financial well-being of financial institutions.

The analysis is analogous for households. Again, we can identify two general effects: rising borrowing and debt-servicing costs, and easing asset prices.

The following table shows the summary balance sheet of the UK household sector in 1995 and 2021.

Source: National balance sheet estimates for the UK: 1995 to 2021 (January 2023) and series RPHA, ONS

The total value of the sector’s net wealth (or ‘worth’) is the sum of its net financial wealth and its non-financial assets. The former is affected by the value of the stock of outstanding mortgages, which we can see from row 3 in the table (‘loans secured on dwellings’) has increased from £390 billion in 1995 to £1.56 trillion in 2021. This is equivalent to an increase from 70 to 107 per cent of the sector’s annual disposable income. This increase helps to understand the sensitivity of the sector’s financial position to interest rate increases and the sizeable cash flow effects. These effects then have implications for the sector’s spending.

Housing is also an important asset on household balance sheets. The price of housing reflects both the value of dwellings and the land on which they sit, and these are recorded separately on the balance sheets. Their combined balance sheet value increased from £1.09 trillion (£467.69bn + £621.49bn) in 1995 to £6.38 trillion (£1529.87bn + £4853.16bn) in 2021 or from 128% of GDP to 281%.

The era of low inflation and low interest rates that had characterised the previous two decades or so had helped to boost house price growth and thus the value of non-financial assets on the balance sheets. In turn, this had helped to boost net worth, which increased from £2.78 trillion in 1995 to £12.29 trillion in 2021 or from 319% of GDP to 541%.

Higher interest rates and wealth

The advent of higher interest rates was expected not only to impact on the debt servicing costs of households but the value of assets, including, in the context of this blog, housing. As Chart 3 in the previous blog helped to show, higher interest rates and higher mortgage repayments contributed to an easing of house price growth as housing demand eased. On the other hand, the impact on mortgaged landlords helped fuel the growth of rental prices as they passed on their increased mortgage repayment costs to tenants.

Higher interest rates not only affect the value of housing but financial assets such as corporate and government bonds whose prices are inversely related to interest rates. Research published by the Resolution Foundation in July 2023 estimates that these effects are likely to have contributed to a fall in the household wealth from early 2021 to early 2023 by as much as £2.1 trillion.

The important point here is that further downward pressure on asset prices is expected as they adjust to higher interest rates. This and the impact of higher debt servicing costs will therefore continue to impact adversely on general financial well-being with negative implications for the wider macroeconomic environment.

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Questions

  1. What possible indicators could be used to assess the affordability of residential house prices?
  2. What do you understand by the concept of the monetary policy transmission mechanism? How do the housing and mortgage markets relate to this concept?
  3. What factors might affect the proportion of people taking out fixed-rate mortgages rather than variable-rate mortgages?
  4. What is captured by the concept of net worth? Discuss how the housing and mortgage markets affect the household sector’s net worth.
  5. What are cash-flow effects? How do rising interest rates effect savers and borrowers?
  6. How might wealth effects from rising interest rates impact younger and older people differently?
  7. Discuss the ways by which house price changes could affect household consumption.