Economic View: Hard times on the horizon

The sales are always a confusing time but the reductions this year seem more real than they have in the past, so that there may be a hint of desperation in the price-slashing.

I don't know how it feels in the rest of the country but in London things seem quiet. The Christmas retail season everywhere was suitably muted, as some of the store groups have discovered to their cost. The sales are always a confusing time but the reductions this year seem more real than they have in the past, so that there may be a hint of desperation in the price-slashing.

But some slowing of the retail boom was always to be expected. The question going forward is whether something untoward is happening: the first signs of an actual fall in consumption.

No one I have seen is predicting this yet in the UK, although it is happening in Japan and Germany. The mainstream forecasters are talking of consumption growth here coming down from 4-5 per cent annual growth to more like 2-3 per cent. That may well turn out to be right. But the risks are on the downside: that people will cut back more suddenly and the economy will slow as a result.

At the moment the evidence supports the more hopeful view. Ask consumers if they are worried and the answer, until recently, at least, seems to be "not really". The December consumer confidence survey showed a negative balance against a positive one in November but the level of gloom is nothing like that of the early 1990s downturn (see left-hand graph above). Still, consumer confidence polls could have become a lagging indicator instead of a lead indicator. People lose confidence suddenly and change their habits immediately, then they tell pollsters afterwards. If that December downturn deepens in the next month or two, then it would be significant.

There are, however, three main reasons for such caution: the effects of house prices falling, the impact of higher taxation in the coming Budget, and a longer-term realisation that people have to save more.

For the past four years consumption has been supported by the huge amounts of money being borrowed against the security of homes, known as equity withdrawal. On Friday the Bank of England revealed that during the third quarter of last year equity withdrawal reached £11.98bn, or 6.6 per cent of post-tax income. That is not quite as high as the peak of more than 8 per cent in 1988 (middle graph) but it cannot be sustainable.

People have huge debts relative to income – more than 1.2 times income, in fact, which is higher even than it was in 1988. True, the servicing cost of that debt is more reasonable, thanks to low interest rates (right-hand graph), but obviously we would be very vulnerable were rates to rise. Even if short rates are held down (as they will be for several months to come), long rates seem to be starting to rise and that will then make the option of a fixed-rate mortgage less attractive. People are quite sensitive to that.

The second reason for concern is the tax rises in the pipeline. National insurance goes up by 2 per cent, half of which is notionally paid by employers, half by employees. I say "notionally" because although the money is deducted in two chunks, the pot from which it is drawn is the same pot: the pool of money available to pay employees. So wage rises will be lower than they otherwise would have been, or maybe employers will nudge down their payrolls. Either way, it eventually comes out of consumption.

Further, there may be a psychological impact as people see the effect on their salary slips. It is a warning that taxes are on the rise and this increase may by no means be the last. The national insurance increases, in any case, will be accompanied by increases in council tax and by other, less noticeable changes. And if things go wrong and Gordon Brown has miscalculated his tax receipts by even more than he thought he had, we know who will have to foot the bill. So we should be prepared. If the Chancellor has now kissed goodbye to Prudence, maybe we consumers should embrace her instead.

Then, finally, there are all the warnings about the declining value of people's pensions, the need to work longer, the need to save more, and so on. The rhetoric about later retirement, coupled with the decline in the size of many people's pension pots, has quite suddenly changed the mood of anyone who is even a decade off retirement. And the 50-somethings are big spenders: they have the largest amount of discretionary income – money that is not committed – of any age group. Now more of that cash has to be set aside for retirement than would have been the case two years ago.

The scaling back of equity withdrawal can be quantified. If the 6.6 per cent of post-tax income were scaled back to, say, 1-2 per cent, that would be £9-10bn a quarter – up to £40bn a year – less for funding consumption. That is huge. GDP is about a trillion so you are talking 4 per cent of GDP.

The other factors, concerning the impact of the rise in taxes, are harder to quantify because we don't know whether people will try to offset the taxation to some extent by borrowing, or be frightened by it and save still more. As for the longer-term concern about pensions, who knows? Maybe it will take another five years or more for habits to adapt and people to start setting aside more for their old age.

But it is a triple-whammy hitting consumption over a very short period. Maybe the professional forecasters will be right and the consumer boom will end with a fizzle, not a bang. But maybe not. Watch the shops in the next three months. I don't think it will be an easy time.