Static incomes + inflation = falling living standards

14th Feb 2013

How does inflation affect our real cash incomes? Donald Hirsch explains.

Donald Hirsch illustrates the effect of inflation on our real cash incomes.

Why should we get so worried when the Governor of the Bank of England makes a modest adjustment in his inflation forecast, guessing that prices will rise by around 3 and then 2.5 per cent in the next two years, rather than about half a per cent more slowly?

Before the present economic downturn, most people would not have expected this to make much difference to their lives, partly because earnings or benefits were expected to rise at least by inflation. But today, where so many incomes are static in money terms, every percentage point rise in prices can represent a one per cent fall in living standards.

The link between inflation and falling standards of living has been particularly strong for people getting their income from public sources, since deficit reduction is being achieved partly by rigid cash limits. Public sector workers are undergoing a three-year pay freeze, which will see the real value of their pay shrink by over 10 per cent. And from this year, people on benefits and tax credits will see their income from the state rise by a fixed 1% a year for three years, regardless of level of inflation. In both cases, the faster prices rise, the harsher the real-terms cut will be.

How much difference will this make to people’s cash incomes? Take the example of a couple with two children on low earnings of £20,000 a year (with one partner working full time and one working three days a week, both on the Minimum Wage). They get their wages topped up by around £7,000 in Child Tax Credit and Child Benefit. Over a three-year period, if inflation runs at 3% a year, this annual package will fall in value by about £500; if inflation is on target at 2%, the fall will be just under £300.

These sums will make a real difference to families struggling to make every penny count. As the research I do on Minimum Income Standards for JRF is consistently showing, the shortfall of income relative to need for the worst-off families widens a bit each year, so the cumulative effect keeps on growing.

In this way, the efforts of a central banker to meet monetary targets are now having a direct impact on people’s lives. Mervyn King’s successor, the Canadian Mark Carney, has talked of "flexible inflation targeting", but will he ultimately be a better master of his tools for containing inflation than Mr King has been?

His technical skills will matter a lot to some of the worst-off families in Britain.