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Cocktail of falling inflation rising real incomes and robust economic growth tastes sweet on consumers palate

Consumer spending continued to support overall growth in the economy in the last quarter of 2014. The second estimate of GDP remained unchanged suggesting the economy grew by 0.5% with household spending accounting for 0.3 percentage points of this growth. Consequently annual growth for the UK remained at 2.6% which rounded off an impressive year -the fastest growth of any G7 economy.

Chart 1

Source ONS

We believe 'Goldilocks' conditions of low inflation robust wage growth improving consumer confidence and stronger macroeconomic fundamentals will underpin consumer spending. Inflation fell to an all-time low of 0.3% in January driven by falling prices in transport food and energy. According to the ONS average store prices fell by 3.1% in January 2015 year-on-year. This was the largest annual fall since records began in 1997. The largest contribution once again came from petrol stations which fell by 15.1% the largest year-on-year fall in this store type on record. Importantly these components of the consumer basket are relatively income insensitive hence as energy prices fall households energy consumption is unlikely to alter significantly. Therefore deflation in areas of non-discretionary spending transport energy and food is likely to have a material impact on consumer spending in more income sensitive areas like consumer electricals homewares and some big-ticket purchases. Admittedly some households may decide to increase their levels of saving but with consumer confidence near pre-crisis levels we believe that households will be more inclined to spend.

We forecast that consumer spending will rise at an annual rate of c.3.0-3.5% this year outpacing growth in the economy. Indeed households incomes rose by 1.2% on the quarter outpacing nominal spending of 1.0% - meaning the recovery is no longer being supported by households saving less.

Consumer confidence is expected to remain at its present high levels with CPI expected to fall in the coming months and nominal wage growth accelerating. After a five year absence wage growth has exceeded inflation for four consecutive months.

With past falls in the price of oil continuing to feed-through the supply chain a number of energy providers have announced cuts pressure on CPI remains on the downside. Indeed the Producer Price Index an indication of costs faced by retailers fell for the seventh consecutive month and was -1.8% in January. These savings are likely to be passed on to consumers keeping a lid on inflation.

Meanwhile survey evidence suggests that average earnings will continue to rise as slack in the labour market diminishes. The Bank of England has forecast wages to rise by 3-3.5% in 2015. Although the prospect of deflation could dampen wage growth we dont believe this to be the most likely scenario given it will be brief.

Chart 2

Source ONS

House price rises remained steady in January up by 6.7% year-on-year compared with 7.2% in the previous month. With mortgage approvals rising for the second consecutive month and mortgage rates remained at an all-time low we expect the housing market to gain traction again in the coming months. Recent changes to stamp duty will also provide further support to the housing market coupled with greater credit availability from banks. This will help support sales particularly in home and big ticket items such as kitchens and bathrooms.

A boost in household borrowing looks likely for 2015. Positive momentum for borrowing has been brewing in the last six months and with confidence at near all-time high levels consumer appetite for credit is rising.

However the global backdrop has become choppier in recent months with emerging market economies having deteriorated the euro area remaining weak and the geopolitical tensions in Russia Ukraine and the Middle East compounding uncertainty. The outcome of vital talks with Greece is also a key factor in determining confidence.

Closer to home the General election in May and the prospect of earlier than anticipated interest rate rises also make forecasts trickier.

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