UK inflation: Higher and higher and…

It’s official: The energy price cap will rise by 80%. This will push inflation to around 13% in October, but even that won’t be the end of it. The huge surge in wholesale prices means there is likely to be another rise in the energy price cap in January, sending inflation to a peak of 15% – its highest level since 1980.

What’s more, many businesses are due to renew their energy contracts in October, which will see their energy costs go as much as four or five times higher! These huge cost increases will have to be passed on to consumers, leading to higher inflation across the board.

The result is likely to be inflation that remains high throughout the whole of 2023. As a consequence, the Bank of England will probably have to raise interest rates even more: Expect another rise of 50 basis points (bps) in September and for rates to peak at 3% early next year.

Inflation peak higher up and further away

As if the 80% rise in energy prices wasn’t enough, financial markets are suggesting that electricity and natural gas prices will rise to record levels over the winter. At current levels, Ofgem could raise the energy price cap by another 50% to 75% in January; that would be enough to push inflation to 15% or even a little higher at the start of 2023.

Financial markets then expect falls in prices over the rest of next year, but prices are likely to remain four or five times higher than their pre-pandemic level. However, energy prices over the winter will be determined by two factors that neither the energy companies nor the government have control over:

• First, how much natural gas will Russia export? Russia currently exports only around 20% of what it normally does. If Russia further decreases supply, prices will inevitably rise even higher.
• Second, how cold will this winter be? A cold winter would lead to higher demand for natural gas, boosting prices for both gas and electricity since around 40% of UK electricity generation is fired by natural gas plants. Remember 2018’s ‘Beast from the east’? During that storm, natural gas demand increased by 55% when compared to normal levels. Alternatively, a mild winter would reduce demand and prices.

We have assumed that prices roughly follow the path indicated by financial markets. But there are huge risks around the path prices and, therefore, inflation will take over the winter.

Spare a thought for businesses and their bills

While most of the media coverage has focused on what rising energy prices mean for households, businesses are facing even larger increases. Many businesses renew their annual contracts in October and will be facing cost increases of 400% to 500%.

Given that energy accounts for around 5% of a typical services firms’ costs, manufacturing firms can spend a much larger proportion on energy. A 400% increase in energy bills would see their total costs rising by around 20%. Cost increases of this magnitude will have to be passed on to customers.

These second-round effects will further add to inflation over the next year. The MPC estimates that by October the direct contribution of energy to CPI inflation will be 6.5ppts, and (because businesses put up their prices to recoup higher energy prices) the indirect contribution will be another 1ppt. So, of that 13% inflation rate in Q4, at least 7.5ppt will be due to higher gas and electricity prices.

What’s more, many businesses, especially energy intensive ones, will reduce their energy bills by reducing their output. In fact, there are already reports of chemical factories shutting down and restaurants opening only on weekends.

BoE will still raise rates

All else being equal, higher energy bills and inflation would be a bigger drag on real household incomes and result in a bigger recession. However, it is becoming more likely that soon after taking office the new Prime Minister will announce a larger household support package.

We’ve assumed a support package of around £40bn, which is a bit over 1% of GDP. That won’t be nearly enough to offset all the damage to the economy, but it does mean that we think the recession will create a drop in GDP of only around 1% (about half the size of the 1990s recession).

However, the second-round effects mentioned above make it more likely that the Bank of England will raise interest rates by more than that. We think another 50bps hike is probably nailed on in September, and now anticipate that interest rates will peak at 3% early next year.