The surge in energy prices will ensure that real disposable incomes fall next year. Businesses could feel the pain more acutely than individual consumers, as they aren’t protected by a price cap and that will cause them to raise prices or even curtail production.
Both factors will slow the economic recovery in the last few months of this year and into 2022. A more moderate pace of economic growth should give the Monetary Policy Committee (MPC) some breathing room before it tightens monetary policy. We have pencilled in the first rate hike in May 2022.
Energy prices may have peaked, electricity and natural gas prices have fallen by about 10% in the last week as Russia said it would send more natural gas to Europe, but prices for both forms of energy are still about five times as high as they were in 2019, before the pandemic, and look set to remain high through the winter.
Households’ real disposable incomes could fall by about 1% next year, for several reasons. If prices do remain high over winter, Ofgem (the government department responsible for regulating energy companies) could raise its energy price cap by another 30% in April. Combined with high inflation elsewhere, tax rises and lower fiscal spending due to the ending of the furlough scheme and the reduction in universal credit, and you can expect a crimp in consumer spending next year and curbed economic growth. Indeed, we recently revised down our forecast for 2022 by almost one percentage point, to 4.8%.
However, the situation could be even worse for businesses, who aren’t protected by a price cap in the way that consumers are. Admittedly, businesses that use large amounts of power can hedge their costs, i.e. they buy power in advance and lock in the price. But many smaller businesses won’t have been able to hedge at all, and bigger firms will face much higher energy bills as their hedges expire.
All businesses affected, but not equally
There is a wide disparity between the amount that firms spend on energy. ‘Intermediate consumption’ is the inputs, excluding labour and investment, that firms use to produce what they sell to consumers. The chart below shows what proportion of businesses’ intermediate consumption goes on energy, services and products.
Firms in finance and insurance spent about 1% of their non-labour costs on energy in 2018, and a surge in energy prices is unlikely to do too much damage to their bottom lines given that labour costs make up the majority of costs for these types of businesses.
However, companies in the production industries spend about 16% of their non-labour costs on energy. A significant rise in energy costs could make many of these businesses unsustainable. So the findings of September’s Business Impact of COVID-19 Survey weren’t that surprising – half of manufacturing firms said costs were rising more quickly than normal, but just 8% of IT firms said the same.
It’s clear that energy-intensive firms won’t be able to absorb all of the cost of rising energy bills, which explains why a quarter of manufacturing firms said they were raising their selling prices more quickly than normal (only 2% of IT firms are doing that).
There are numerous reports of firms that can’t easily pass on costs so are preparing to curtail production instead. It’s one reason why the economic recovery looks to have stalled in September.
A 20% rise in energy bills in April 2022 would probably mean that inflation will peak at about 4.5% in April, rather than at just over 4% in November, and would stay above the Bank of England’s 2% target for the whole of 2022.
As such, it’s understandable why the MPC has become more concerned about inflation. But higher interest rates will do nothing to bring gas and electricity prices down. The MPC knows this, so it will probably continue to talk like a hawk and walk like a dove as it waits for the knots caused by snarled global supply chains to straighten out. This is why we’re not expecting a rate hike until next year, unlike the financial markets that are betting on November or December.
When viewed in the rear-view mirror, the energy crisis of 2021 is likely to be seen as the first major bump in the road away from fossil fuels and towards natural gas. There will inevitably be more such bumps over the coming decades, and middle market business leaders should prepare for a world where energy efficiency is increasingly important.