Have consumers scented the wind of change?

"When The facts change, I change my mind. What do you do, sir?" John Maynard Keynes, who supposedly came out with this remark, was a jolly clever chap. It's probably fair to say, though, that facts themselves don't change. It's only our perception of the facts that changes: the truth itself, at least for X-Files fans, is always out there. Indeed, the X-Files probably took their cue from René Descartes who, by declaring that "I think, therefore I am", made us all sleep easier, confident that knowledge is possible and that there is at least one universal truth.

"When The facts change, I change my mind. What do you do, sir?" John Maynard Keynes, who supposedly came out with this remark, was a jolly clever chap. It's probably fair to say, though, that facts themselves don't change. It's only our perception of the facts that changes: the truth itself, at least for X-Files fans, is always out there. Indeed, the X-Files probably took their cue from René Descartes who, by declaring that "I think, therefore I am", made us all sleep easier, confident that knowledge is possible and that there is at least one universal truth.

I'm not entirely convinced that the Bank of England's Monetary Policy Committee (MPC) indulges in frequent discussions about epistemological issues but, although the facts themselves haven't really changed, the Bank's perception of those facts may have begun to alter. The MPC had recently been digging its talons into the UK economy, showing a gradually more hawkish intent. Three months ago, the committee was unanimous in its call for interest rates to remain unchanged. Then, in February, Paul Tucker broke ranks, voting in favour of a rate increase, to be joined at the March meeting by Andrew Large. Not surprisingly, financial markets began to believe that an interest rate increase was imminent.

Yet, if anything, recent data suggest that the case for a rate increase has weakened, not strengthened. And the main reason for this sudden shift lies with the consumer. You may recall the Bank of England arguing only a few months ago that there was little in the way of any linkage between the housing market and consumer spending. Members of the MPC suggested that consumer spending had been remarkably soft given the extraordinary gains in house prices in recent years, implying that the economy as a whole faced few meaningful risks from a softening of house prices. Many people nodded sagely, thinking that the Bank of England had stumbled upon a structural change in the UK economy: house prices could move all over the place but consumers would simply shrug their shoulders as if nothing real had happened.

Recent evidence tends to undermine that conclusion. Admittedly, house prices have not collapsed, despite the soft Nationwide data published last week. Consumer spending, however, has been disappointingly weak. The March CBI Distributive Trends Survey suggests that retailers are having a torrid time. Retail sales themselves have ground to a halt in recent months, down in volume terms by 0.6 per cent in the three months to January compared with the three months to October. And, within the National Accounts, consumer spending increased by just 0.4 per cent in the final quarter of 2004 and could easily slip back further in the first quarter of 2005.

So why have consumers seemingly lost their appetite to spend? One possibility is that they haven't, and that I've just asked a meaningless question. Mervyn King, the Bank's Governor, argued earlier this year that data were not to be trusted over the Christmas period, in part because the timing of sales and associated discounting was so variable from one year to the next, creating havoc with the seasonal adjustment process that attempts to smooth out retail spending on a monthly basis. This, though, looks like an increasingly forlorn argument: as time's gone by, the retail sector has descended into a state of perma-gloom.

A more plausible argument is quite simply that there is a relationship between the housing market and consumer spending and that the Bank's denials were, in part, a reflection of unease about the fragile foundations upon which the gains in consumer spending in recent years have been built. The Bank's job is, in part, to instill confidence in the national economic fabric and it is hardly going to tell everyone that the economy is doomed as a result of earlier housing excesses, particularly if those excesses were, in part, a reaction to unusually low rates of interest. But its policy of denial now looks increasingly less credible, as consumers seemingly become a lot less enthusiastic about spending their hard-earned cash.

The puzzling feature of this story is that house prices have yet to crash. While it's true that house price inflation has eased off considerably in recent months and, in some regions, prices have declined modestly, we haven't yet seen the kind of wholesale collapse that some economists have been warning about. So if it's the case that homeowners' worst nightmares haven't come true, why is it that consumers have become more cautious?

One way to approach this issue is to examine the motivations that persuaded consumers to carry on spending in recent years when many of the usual inducements for trips down Oxford Street or to the Bluewater shopping centre were simply not there. Higher oil prices have eroded real wages and higher taxes have eroded real incomes. Rising interest rates themselves would normally have acted as a restraining influence as well. Until recently, though, consumers had ignored these constraints: instead, they'd carried on swiping their credit cards and tapping in their pin numbers.

Credit, nevertheless, provides the clue to both consumers' resilience in recent years and to their new-found vulnerability. When house prices were rising rapidly, consumers were happy to carry on borrowing, content in the knowledge that, no matter how many debts they had, the rising value of their most important asset would always bail them out. Now that house prices have stabilised, consumers no longer feel quite so confident. The old swagger has gone, to be replaced by a new sense of caution.

Mortgage equity withdrawal - borrowing on a secured basis against the value of your house - rose dramatically in the early years of this decade. Without it, I suspect consumer spending would have been a lot weaker, leaving the UK as vulnerable to recession as its competitors proved to be after the equity market bubble burst in 2000 and 2001. The British consumer's desire for leverage was, in many ways, a blessing, keeping the economy going when industry was really beginning to suffer.

Now, though, mortgage equity withdrawal is falling back rapidly. People are still borrowing against the value of their houses, but their willingness to do so is fading fast. The Bank of England has frequently argued that mortgage equity withdrawal is, these days, not directly related to consumer spending: instead, the older generation is selling its houses to the younger generation and squirreling the cash profits away for steady expenditure during retirement. It's difficult to see, though, why this process of generational wealth transfer should have come to such an abrupt end over the last year or so, and it's equally difficult to see why, if the money were simply being saved for a rainy day, retail sales should have slowed so suddenly in recent months.

The relationship between house prices and consumer spending was always an imprecise one, but it was always there. As things are turning out, house prices may have fallen by less than feared, but consumer spending is weakening nonetheless. Consumers may sense that something has changed. With housing transactions having fallen dramatically over the last 12 months, consumers can no longer be sure that their prized asset is quite so liquid. Against that background, continued increases in borrowing no longer carry the same attractions.

The truth is certainly out there but, at the moment, the Bank of England is having some difficulty piecing the component parts together. Like Descartes, members of the Monetary Policy Committee certainly have some thinking to do. Unless wage growth picks up in the next month or so, it may well be that the MPC will soon be indicating that base rates have peaked after all.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com