Households face the most dramatic squeeze in living standards since the 1920s, the Governor of the Bank of England warned, as he reacted to the shock disclosure that the economy was shrinking again.
Families will see their disposable income eaten up as they “pay the inevitable price” for the financial crisis, Mervyn King warned.
With wages failing to keep pace with rising inflation, workers’ take- home pay will end the year worth the same as in 2005 — the most prolonged fall in living standards for more than 80 years, he claimed.
Mr King issued the warning in a speech in Newcastle upon Tyne after official figures showed that gross domestic product fell by 0.5 per cent during the final three months last year. The Government blamed the unexpected reduction — the first since the third quarter of 2009 — on the freezing weather that paralysed much of the country last month.
But there were fears that the country was poised to slip back into recession, defined as two successive quarters of negative growth. Economists said the situation was “an absolute disaster”.
Labour accused ministers of jeopardising recovery by pushing ahead with public spending cuts too quickly.
Mr King said he was unable to offer any imminent hope of a rise in interest rates in coming months because of the poor economic outlook. Savers and “those who behaved prudently” would be among the biggest losers in the squeeze, he admitted.
Disposable household income has been hit by sharp increases in the cost of food, fuel and tax, coupled with restricted wage rises for most workers. Last year, take-home pay fell by about 12 per cent, official figures showed, and the trend was expected to continue in 2011.
The governor warned that the Bank “neither can, nor should try to, prevent the squeeze in living standards”.
He said that the economic figures were a reminder that the recovery will be “choppy”. However, he said the biggest threat facing the Bank’s Monetary Policy Committee, which sets interest rates, was rising inflation.
The Bank is expected to use interest rates to keep inflation below two per cent, but the governor said inflation could rise “to somewhere between four per cent and five per cent over the next few months”.
He claimed that rising inflation had been caused largely by increases in global oil and commodity prices, and tax rises such as the increase in VAT introduced at the beginning of the year, which the Bank was powerless to control.
“In 2011, real wages are likely to be no higher than they were in 2005,” he said. “One has to go back to the 1920s to find a time when real wages fell over a period of six years.
“The squeeze on living standards is the inevitable price to pay for the financial crisis and subsequent rebalancing of the world and UK economies.”
Mr King insisted that the Monetary Policy Committee could not have increased interest rates from their current record low level to tackle the rise in inflation.
“If the MPC had raised the Bank Rate significantly, inflation might well have started to fall back this year, but only because the recovery would have been slower, unemployment higher and average earnings rising even more slowly than now,” he said.
“The erosion of living standards would have been even greater. The idea that the MPC could have preserved living standards, by preventing the rise in inflation without also pushing down earnings growth further, is wishful thinking.”
He added: “Monetary policy cannot be based on wishful thinking. So, unpleasant though it is, the Monetary Policy Committee neither can, nor should try to, prevent the squeeze in living standards, half of which is coming in the form of higher prices and half in earnings rising at a rate lower than normal.”
“The Bank of England cannot prevent the squeeze on real take-home pay that so many families are now beginning to realise is the legacy of the banking crisis and the need to rebalance our economy.”
The comments represented one of the governor’s starkest warnings yet. His claim that the banking crisis was behind the ongoing squeeze on living standards comes at a sensitive time, as banks prepare to announce multi-million pound bonuses for their executives.
Mr King expressed sympathy for savers and highlighted the failure of lenders to pass on cuts in interest rates. “I sympathise completely with savers and those who behaved prudently now find themselves among the biggest losers from this crisis,” he said. “But a return to economic stability from our fragile condition will require careful and well-judged steps looking beyond the next few months.”
Addressing the problems of borrowers, he added: “Households and small businesses with little housing equity may be unable to borrow at all or are able to borrow only in the unsecured market – where rates are much higher than before the crisis.”