What is the cost of living crisis?

The ‘cost of living crisis’ refers to the fall in ‘real’ incomes (that is, adjusted for inflation and tax) that the UK has experienced since late 2021. It is being caused by a combination of high inflation outstripping wage increases and upcoming tax increases that have squeezed incomes for many households. The crisis is expected to worsen when planned tax increases are brought in from April. This explainer details the causes and extent of the crisis.

In early February, the government announced some measures to respond to high energy prices, a particular flashpoint of the crisis. But even after accounting for these policies inflation is expected to increase much more quickly than post-tax incomes.  

How high is inflation?

Inflation is calculated as the average change in the price of typical goods and services purchased by UK households over 12 months. This is tracked using the Consumer Price Index (CPI), calculated by the Office for National Statistics using a sample of 180,000 prices of 700 common consumer goods and services.[1] The latest data has the current CPI at 5.4% in the 12 months to December 2021. The Bank of England aims to keep the CPI rate of inflation at 2% plus or minus 1% (i.e. between 1% and 3%) and adjusts interest rates to achieve this.

However, CPI excludes the cost of housing. An alternative measure of inflation produced by the ONS, the Consumer Prices Index with Housing (CPIH), is in some ways a better measure of inflation as it includes owner occupiers’ housing costs. Current CPIH is currently a little lower than CPI, at 4.8%.[2]  

Which prices are increasing fastest and why?

A rapid increase in energy costs, particularly the wholesale price of gas, has been a key driver of the recent increases in inflation. Housing and household services (which include energy) contributed to over a quarter of CPIH inflation in December 2021.[3] Factors including increased demand from Asia, depleted gas storage supplies in Europe, tensions between Ukraine and Russia (a major supplier of European gas) and unexpected outages in Liquified Natural Gas production have contributed to the large price increases since mid-2021.[4] The weekly average price of gas peaked at 12.8p per kilowatt hour in mid-December 2021, an eightfold increase on the price a year previously.[5]

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.[6]Consumers have been partially protected so far, thanks to fixed-price contracts and the government’s energy price cap that limits the cost of the ‘standard variable tariff’ (SVT) that most households face.

Disruption to global supply chains has also increased prices. Pandemic shutdowns of factories in Asia have caused a shortage of semiconductors, an important component in common consumer goods such as cars and home appliances, substantially pushing up the price of second hand car as consumers switched demand towards used vehicles. Global shipping costs have also increased, as shipping firms reduced capacity by 11% during the pandemic in anticipation of reduced demand. The average cost of shipping a large container increased fourfold in the 12 months to September 2021.[7] This has increased the price of commodities such as timber and other imported products.

How is inflation expected to change in the coming months?

The latest Bank of England forecast has inflation peaking at 7.25% in April 2022. This is largely driven by the £693, or 54%, increase from 1 April of the energy price cap. The government’s policies in response to energy price increases – announced after the Bank presented its forecast – means the peak in inflation is likely to be slightly lower than originally forecast, but will still be very high by recent historical standards.[8]  

Inflation is expected to remain high for the next two years: the Bank expects that inflation will not reach its 2% target until the second quarter of 2024.[9]

Are incomes increasing as quickly as prices?

No. Inflation is outstripping increases in nominal wages so incomes will fall in real terms. Wage growth was strong as the country emerged from periods of lockdown in the summer of 2021, with an increase of 8.8% in the year to June 2021 (though this was partially driven by a recovery from the sharp drop in wages due to large numbers of workers being furloughed in 2020). However in the last year it has not been sufficient to keep pace with inflation, with wage growth at 4.2% in the year to November 2021. The Bank of England forecasts wage growth of 4.75% in 2022.  

Households that receive a large part of their income from the government, through working age benefits or the state pension, see their incomes uprated each year. Benefits and state pensions are currently set to increase by inflation in April 2022. But the increase in April will only be 3.1% because that was the CPI inflation rate measured by the ONS last September, the usual reference month for deciding the annual April increase in benefits and the state pension.[10]

Recent changes to Universal Credit also mean that many benefit claimants will be worse off this April than they were a year ago. The £20 a week increase, brought in to help recipients whose income suffered as a result of the pandemic, ended in September so – even with changes to in-work benefits such as the reduction of the ‘taper rate’ and an increase in the work allowance by £500 – three quarters of households on Universal Credit are set to receive less this April than a year ago.[11] Recipients who do not work at all will lose the entire Covid uplift, amounting to £1,040 a year.

What are the tax increases planned for April?

The tax increases announced last year were larger (as a share of national income) than those announced in any year since 1993. A one-year increase of 1.25 percentage points in National Insurance contributions is planned for April, ahead of the new health and social care levy coming into force in 2023.

The income tax personal allowance and higher rate threshold will also be frozen for four years from April, instead of increasing in line with inflation as planned. This amounts to a tax rise as many more people will be dragged into higher rates of tax as their incomes increase faster than the thresholds.

This means that wages alone are unlikely to cushion the blow for many workers: the Institute for Fiscal Studies (IFS) has calculated that wages would need to increase by 9% in April to prevent real post-tax wages from falling.[12]

Are poorer households worse affected by the cost of living crisis than richer ones?

Anti-food poverty campaigner Jack Monroe has called on the ONS to change the way it measures and reports the cost of living, arguing that poorer households experience higher inflation.[13]

Recently published ONS analysis, which accounts for the share of different households’ budgets spent on broad product categories, suggests that the inflation rate is currently similar on average at different income levels.[14] However, Monroe has emphasised that within product categories (and specifically food), the prices of cheaper goods – that poorer households are more likely to rely on –  are increasing more quickly. This would not be captured in the existing ONS analysis; it is planning to publish more granular data soon.

Even using the ONS’s current approach, inflation rates are likely to be higher on average for poor households in April when energy prices rise because energy accounts for a higher share of their budget. Even after the government’s announcement to alleviate the increase, it will still account for a substantial increase in inflation in that month.

Even if the inflation rate were the same on average for lower-income and higher-income households, the impact is still likely to be felt more for those at the bottom. Poorer households have less disposable income and less flex in their budget if and when costs increase. While a richer household might be able to absorb higher energy costs, for example by reducing how much it saves, that option may not be available for many low-income households.

The worst-affected households will be those with lower incomes who also spend disproportionately more on energy costs. The focus in this section so far has been average inflation for rich and poor households, but the average masks a lot of variation. IFS research indicates that, although the poorest tenth of households spend an average of 4.8% of their income on gas, a tenth of this group spend 12% or more of their income on gas.[15] Energy price increases will already be affecting this group more than others, and the April increase will compound this further.

  1. www.ons.gov.uk/economy/inflationandpriceindices/articles/whatsinthebasketofgoods70yearsofshoppinghistory/2016-07-21
  2. www.ons.gov.uk/economy/inflationandpriceindices
  3. www.ons.gov.uk/economy/inflationandpriceindices/bulletins/consumerpriceinflation/december2021#contributions-to-the-annual-cpih-i…
  4. www.iea.org/news/statement-on-recent-developments-in-natural-gas-and-electricity-markets
  5. www.ons.gov.uk/economy/economicoutputandproductivity/output/datasets/systemaveragepricesapofgas
  6. www.ons.gov.uk/peoplepopulationandcommunity/housing/datasets/energyefficiencyofhousingenglandandwalescountryandregion
  7. www.economist.com/finance-and-economics/a-perfect-storm-for-container-shipping/21804500
  8. [viii] [Link to resolution foundation]
  9. www.bankofengland.co.uk/monetary-policy-report/2022/february-2022
  10. www.gov.uk/government/news/state-pension-and-benefit-rates-for-2022-to-2023-confirmed
  11. www.resolutionfoundation.org/publications/taper-cut/
  12. https://ifs.org.uk/publications/15905
  13. www.theguardian.com/society/2022/jan/22/were-pricing-the-poor-out-of-food-in-the-uk-thats-why-im-launching-my-own-price-index
  14.  https://twitter.com/JamesSmithRF/status/1489219326175498248https://www.ons.gov.uk/economy/inflationandpriceindices/bulletins/cpi…
  15. https://ifs.org.uk/publications/15834
Update date: 
Monday, February 7, 2022

Original source – The Institute for Government

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