The cost of living crisis explained; what is it and what caused the cost of living crisis?

Which prices are increasing fastest?

A rapid increase in energy costs, caused by a rise in the wholesale price of gas, has been a key driver of the recent increases in inflation. Housing and household services (which include electricity and gas) as well as food and non-alcoholic beverages, made the largest annual contribution to CPIH inflation in February. This is despite the government’s Energy Price Guarantee, capping the unit cost of electricity and gas. In the absence of this intervention an average household’s energy bill would have increased to over £4,000 but household energy payments have still been far more expensive than in previous years. For example, based on typical consumption levels, the average annual gas bill in 2022 was £1,100, nearly double 2021 costs of £600.

Energy prices are expected to fall this year, which is reflected in Ofgem’s energy price cap. In the absence of the EPG, the price cap would have meant an average household faced an annual bill of £4,279 in January-March 2023, falling to £3,280 in April-June 2023. But with the EPG remaining at £2,500, by the end of June, that policy will have saved the average household  £1,100 through lower energy bills since the scheme began in October.

Price increases have become increasingly broad based over the course of this and last year. On the lower end, items such as bikes and wine have increase by 3% at most between February 2022 and 2023, while items such as whole milk and pasta have increased by over 30%.

Why are prices increasing rapidly?

Cost pressures have been apparent since mid-2021, driven by a range of issues from depleted gas supplies in Europe to semiconductor shortages in Asia. Impacts from the pandemic alongside disruptions to global supply chains also increased prices.

The main contribution to higher prices has been the Russian invasion of Ukraine. Many international companies have permanently ceased operations in Russia either to comply with economic sanctions or due to reputational risk. The war has led to a shortage of Ukrainian exports such as essential car parts which has pushed up prices of second hand cars. Agricultural commodities, such as grain and sunflower oil, are the majority of Ukrainian exports, the disruption of which has contributed to increases in global food prices.

The biggest impact has been on gas prices, as Russia has dramatically reduced gas sales to Europe. Although the UK imports only around 13% of its total fuel (oil, gas, LNG, electricity) from Russia, it is still vulnerable to any disruption to the supply of energy to the EU, which is more reliant on Russia for its energy. Due to the integration of energy markets, UK and EU gas and electricity prices move together. The recent announcement by the European Commission to phase out EU imports of Russian oil will likely push up prices in other markets the UK uses, such as Norway and Qatar. Gas is an important source of energy in the UK: nearly 80% of households in England are heated by mains gas and a third of electricity is generated in gas power stations.

Are incomes increasing as quickly as prices?

On the whole, no. Inflation is outstripping increases in nominal wages so incomes will fall in real terms. Wage growth in the last year has not been sufficient to keep pace with inflation, between November 2022 and January 2023 the average growth in total pay was 5.7%.¹⁰

The OBR expects nominal earnings to increase by 5% over 2023 but again inflation is expected to erode these earnings despite its anticipated downward turn. Real household disposable income (RHDI), which measures total household earnings (such as wages and benefits) after tax and accounting for inflation, fell by 2.5% in the 2022 calendar year and is expected to fall by another 2.6% in 2023.

Households receiving a part of their income from the government, through working age benefits or the state pension, see their incomes uprated each year. These were uprated by 10.1% in April 2023 as this was the CPI inflation rate last September, which is the usual reference month used to determine annual uprating. In April 2022, they increased by only 3.1% as that was the inflation rate the previous September.

Alongside the EPG and previous government measures, the one-off Cost of Living Payments 2023/24 are offering more targeted measures to support the most vulnerable. This approach risks leaving some gaps and cliff-edges in support: the means-tested £900 government support is fully available to those entitled to it but anyone just above the threshold receives nothing.

Which households are worst affected by the cost of living crisis?

Some households face a higher effective inflation rate because they spend a higher share of their income on energy and food, the prices of which are increasing fastest. On average, poorer households spend more of their income on these essentials. Based on November ONS price data, the Resolution Foundation estimates that the inflation rate for the poorest 10% of households is 12.5%, in contrast, it’s 9.6% for the richest 10%. Furthermore, richer households who see big increases in the cost of the goods and services they buy may be able to adapt more easily, for example by reducing how much they save each month or changing spending on non-essentials.

The government is providing additional support to those on lower incomes through direct payments but the expected decline in real household incomes means poor households will continue to face hardships. For example, the Joseph Roundtree Foundation has reported that 75% of the bottom 20% of low-income households in the UK (4.3 million) have gone without essentials.

Overall, the worst-affected households are those on low incomes with higher-than-average energy bills (for example if they have a large family). While these households have received additional payments from government, these are not sufficient to match the increase in energy and other costs. The energy price guarantee provides a big benefit to this group, but on average they are still worse affected by the crisis.

How long is the cost of living crisis expected to last?

By 2024, living costs should be increasing by less than household incomes as inflation rates fall. But prices will remain high: inflation measures the change in prices over a 12-month period, and falling inflation only means prices are rising less quickly, not that they are falling.

Based on the latest forecasts, it will take a long time for household incomes to recover to their previous level in real terms. RHDI per person, a measure of living standards will not return to its 2021/22 level until 2027/28. And in that year living standards will still be below pre-pandemic levels in real terms, meaning that the effects of the cost of living crisis are likely to be felt for a long time.

Rising petrol, food and energy prices have pushed many households in the UK and around the world into an unprecedented cost of living crisis. In the UK, in March 2022 the ONS reports that 23% of households found it difficult to pay their monthly bills.

The cost of living crisis is fundamentally caused by higher inflation, and low wage growth Leaving many households worse off in real terms. The crisis has been exacerbated by short-term factors, such as the Ukraine war, but the pressure on living standards has long-term trends, such as low productivity growth and increased market power of firms.

During the Covid pandemic, inflation fell as households cut back on spending. When restrictions were lifted in 2021, two things happened. Households were free to spend accumulated savings from the pandemic, leading to a significant rise in aggregate demand. But, firms were not ready to deal with the surge in demand. Firms had laid off staff and cut back on investment. Also, there were global supply chain issues, from continued lockdowns in China (e.g. severe shortage of containers) Therefore, when we saw a rise in demand in 2021/22, there were also supply shortages, causing rising prices. The inflation of late 2021 was a combination of excess demand (demand-pull inflation) and cost-push (rising costs).

Russian invasion of Ukraine

Just as post-Covid supply chain problems were starting to be resolved, the Russian invasion of Ukraine, caused a further supply shock, causing a surge in oil, gas, energy and food prices. It made those initial problems much worse. At the start of wars, the price of oil typically surges as countries seek to buy more, at the same time, supply was restricted because of Russian sanctions.

We can see a strong link between oil prices and inflation. This is a graph for the US, but it is a similar situation in the UK. UK consumers have seen a dramatic increase in petrol prices from 145.6p per litre in Jan 2022, to 195p per litre in July 2022. This was caused, not just by rising oil prices, but also rising profit margins, as petrol retailers have taken advantage of the rising oil prices, to increase their mark-up.

The Russian invasion and blockade of Ukraine has also caused a global shortage of wheat, sunflower oil and maize, causing serious cost-push inflation around the world.

Profit-push inflation

There is an old adage that a period of high inflation is always a good time for firms with market power to increase their profit margins. Research by the IPPR found

“corporate profits in the UK have increased by 34% since the onset of the Covid-19 pandemic, 90% of those increases made by the top 25 multinationals.”

A worrying trend is that in recent decades many markets have seen an increase in market concentration. (therefore less competition) This decrease in competition is matched by a rise in the profitability of many companies. UK’s Competition and Markets Authority (2022) has found that markups (a measure of profitability) in UK companies have increased by 75 per cent over the last two decades.

The result is that profit-push inflation is another factor behind rising prices. It is particularly striking that whilst energy prices rise to record highs for householders, big energy companies like BP and Shell have posted record profits. For example, in the first three months of 2022, BP’s profits more than doubled to $6.2bn.

UK worse off

Inflation is a global phenomenon with high inflation in the US, and Europe (though still low in parts of Asia). However, given the low growth rate, UK inflation is really quite high. This is partly due to the effect of Brexit. In particular, the depreciation in the value of the Pound has had the effect of rising import prices. Also, Brexit has raised the cost of doing business with Europe and contributed to the low productivity growth.

Long-term problems

Whilst, the Ukraine war and record 9% inflation (highest since the 1980s) have magnified the cost of living crisis, it is not the sole cause. Ever since the great recession of 2009, the UK has experienced low productivity growth and feeble economic growth.

In this climate of poor productivity, it is very difficult to enable significant growth in real wages and real incomes. The poor productivity has also put pressure on the government’s financial position, requiring a rise in the tax burden to finance public services. Yet, whilst taxes have risen, there remains under-investment in the public sector, and an unwillingness to increase public sector pay and state welfare payments.

At the current state of the economic cycle, with poor economic growth, tax rises (higher NI, freezing of thresholds) have further reduced disposable income, but the chancellor felt they were needed given the large post-Covid deficit.

Interest ratesSince 2009, interest rates have been close to zero. A sign of secular stagnation, weak growth and a reluctance for the private sector to invest. Low-interest rates have been used to try and promote economic growth.  However, with inflation rising to 10%, Central Banks are starting to increase interest rates. Although they are still low by historical standards, even a small increase in interest rates will have a big effect on borrowers and mortgage owners who have become accustomed to ultra-low rates. Higher interest rates will increasingly have an effect on the cost of living in the coming months.

Inequality

Another issue with the cost of living crisis is that the effect on low-income groups is proportionately greater. The Bank of England reports

“The share of income spent on taxes and such essential spending varies greatly; for households in the lowest income decile, it accounts for around 90% of their income, relative to around 45% for households in the highest income decile. ”

The high share of income spent on essentials, means they have much less room for manoeuvre. Also, it is these essential goods, (food, energy, heating) that has seen the biggest increase in prices, meaning the cost of living crisis is having a bigger effect on the most vulnerable.

Housing costs

Between 2005 and 2022, the cost of private renting in England has increased nearly 40%

Another long-term structural problem in the UK economy (and others around the world) is the above-inflation rise in house prices and rental prices. Rising house prices have been driven by two main factors. Insufficient supply compared to rising demand, and the environment of ultra-low interest rates, which makes the mortgage costs relatively cheap to buy a house. These two factors have pushed up house prices, meaning first-time buyers face higher mortgage payments as a share of their income. For those unable to get on the property ladder, rents have been rising consistently. The average cost of renting a property in the UK is now £1,060 a month (£1,752 in greater London)

Any good news on cost of living Crisis?

• In the past few weeks, oil price rises have gone into reverse. Whilst the geo-political situation is uncertain. There is a long tradition of oil prices rising to great fanfare, then quietly falling. This should feed into lower petrol prices soon. The news on gas prices and electricity is less promising, with energy bills set to soar in Europe this winter.
• Inflation is good for tax revenues. Inflation leads to higher tax revenues and (is a secret way for improving the nation’s finances). Expect big tax cuts in the UK. Although the long-term situation is dire, you can expect a pre-election give-away.

2021 saw real wage growth as nominal wages rebounded sharply after Covid pandemic. It is unclear whether this real wage growth can return. Recent months have seen more falls in real wages