The UK household-sector puzzle: A low saving ratio but fragile confidence

The latest consumer confidence figures from the European Commission point to consumer confidence in the UK remaining at around its long-term average. Despite this, confidence is markedly weaker than before the outcome of the EU referendum. Yet, the saving ratio, which captures the proportion of disposable income saved by the household sector, is close to its historic low. We consider this apparent puzzle and whether we can expect the saving ratio to rise.

The European Commission’s consumer confidence measure is a composite indicator based on the balance of responses to 4 forward-looking questions relating to the financial situation of households, the general economic situation, unemployment expectations and savings.

Chart 1 shows the consumer confidence indicator for the UK. The long-term average (median) of –6.25 shows that negative responses across the four questions typically outweigh positive responses. In October 2018 the confidence balance stood at –5.2, essentially unchanged from its September value of –5.8. While above the long-term average, recent values mark a weakening in confidence from levels before the EU referendum. At the beginning of 2016 the aggregate confidence score was running at around +4. (Click here to download a PowerPoint of the chart.)

Chart 1 shows two periods where consumer confidence fell markedly. The first was in the early 1990s. In 1990 the UK joined the Exchange Rate Mechanism (ERM). This was a semi-fixed exchange rate system whereby participating EU countries allowed fluctuations against each other’s currencies, but only within agreed bands, while being able to collectively float freely against all other currencies. In attempting to staying in the ERM, the UK was obliged to raise interest rates in order to protect the pound. The hikes to rates contributed to a significant dampening of aggregate demand and the economy slid into recession. Britain crashed out of the ERM in September 1992.

The second period of declining confidence was during the global financial crisis in the late 2000s. The retrenchment among financial institutions meant a significant tightening of credit conditions. This too contributed to a significant dampening of aggregate demand and the economy slid into recession. Whereas the 1992 recession saw the UK national output contract by 2.0 percent, this time national output fell by 6.3 per cent.

The collapses in confidence from 1992 and from 2007/08 are likely to have helped propagate the effects of the fall in aggregate demand that were already underway. The weakening of confidence in 2016 is perhaps a better example of a ‘confidence shock’, i.e. a change in aggregate demand originating from a change in confidence. Nonetheless, a fall in confidence, whether it amplifies existing shocks or is the source of the shock, is often taken as a signal of greater economic uncertainty. If we take this greater uncertainty to reflect a greater range of future income outcomes, including potential income losses, then households may look to insure themselves by increasing current saving.

It is usual to assume that people suffer from diminishing marginal utility of total consumption. This means that while total satisfaction increases as we consume more, the additional utility from consuming more (marginal utility) decreases. An implication of this is that a given loss of consumption reduces utility by more than an equivalent increase in consumption increases utility. This explains why people prefer more consistent consumption levels over time and so engage in consumption smoothing. The utility, for example, from an ‘average’ consumption level across two time periods, is higher, than the expected utility from a ‘low’ level of consumption in period 1 and a ‘high’ level of consumption in period 2. This is because the loss of utility from a ‘low’ level of consumption relative to the ‘average’ level is greater than the additional utility from the ‘high’ level relative to the ‘average’ level.

If greater uncertainty, such as that following the EU referendum, increases the range of possible ‘lower’ consumption values in the future even when matched by an increase in the equivalent range of possible ‘higher’ consumption values, then expected future utility falls. The incentive therefore is for people to build up a larger buffer stock of saving to minimise utility losses if the ‘bad state’ occurs. Hence, saving which acts as a from of self-insurance in the presence of uncertainty is known as buffer-stock saving or precautionary saving.

Chart 2 plots the paths of the UK household-sector saving ratio and consumer confidence. The saving ratio approximates the proportion of disposable income saved by the household sector. What we might expect to see if more uncertainty induces buffer-stock saving is for falls in confidence to lead to a rise in the saving ratio. Conversely, less uncertainty as proxied by a rise in confidence would lead to a fall in the saving ratio. (Click here to download a PowerPoint of the chart.)

The chart provides some evidence that of this. The early 1990s and late 2000s certainly coincided with both waning confidence and a rising saving ratio. The saving ratio rose to as high as 15.2 per cent in 1993 and 12.0 per cent in 2009. Meanwhile the rising confidence seen in the late 1990s coincided with a fall in the saving ratio to 4.7 per cent in 1999.

As Chart 2 shows, the easing of confidence since 2016 has coincided with a period where the saving ratio has been historically low. Across 2017 the saving ratio stood at just 4.5 per cent. In the first half of 2018 the ratio averaged just 4.2 per cent. While the release of the official figures for the saving ratio are less timely than those for confidence, the recent very low saving ratio may be seen to raise concerns. Can softer confidence data continue to co-exist with such a low saving ratio?

There are a series of possible explanations for the recent lows in the saving ratio. On one hand, the rate of price inflation has frequently exceeded wage inflation in recent years so eroding the real value of earnings. This has stretched household budgets and limited the amount of discretionary income available for saving. On the other hand, unemployment rates have fallen to historic lows. The rate of unemployment in the three months to August stood at 4 per cent, the lowest since 1975. Unemployment expectations are important in determining levels of buffer stock saving because of the impact of unemployment on household budgets.

Another factor that has fuelled the growth of spending relative to income, has been the growth of consumer credit. In the period since July 2016, the annual rate of growth of consumer credit, net of repayments, has averaged 9.7 per cent. Behavioural economists argue that foregoing spending can be emotionally painful. Hence, spending has the potential to exhibit more stickiness than might otherwise be predicted in a more uncertain environment or in the anticipation of income losses. Therefore, the reluctance or inability to wean ourselves off credit and spending might be a reason for the continuing low saving ratio.

We wait to see whether the saving ratio increases over the coming months. However, for now, the UK household sector appears to be characterised by low saving and fragile confidence. Whether or not this is a puzzle, is open to question. Nonetheless, it does appear to carry obvious risks should weaker income growth materialise.

Articles

• Sharp slowdown in consumer spending cools UK retail sales

Guardian, Richard Partington (9/10/18)

• UK household saving ratio hit record low in 2017, says Office for National Statistics

Independent, Ben Chu (29/03/18)

• Scottish consumer confidence ‘falling’

BBC News (21/10/18)

• Brexit worries drag on UK consumer sentiment – GfK

Reuters (31/10/18)

• Consumer confidence beginning to resemble an ‘abandoned bowl of porridge’

Marketing Week, Ellen Hammett (31/10/18)

Questions