Rising energy prices will weigh on consumer spending and GDP growth next year. At its meeting on Thursday, 23 September, the Monetary Policy Committee (MPC) should be more concerned about the negative impact on the economic recovery from soaring energy prices than about the upward impact on headline inflation.
The MPC will continue to largely ignore moves in volatile energy commodities and focus on the outlook for the underlying economy, which has weakened a little since its last meeting. We suspect financial markets are getting ahead of themselves in expecting the MPC to hike rates early next year. Instead, the first rate hike will probably come late in the second half of 2022.
The record high in wholesale prices of gas and electricity has a number of causes. A lack of wind to power turbines has increased demand for gas to generate electricity, maintenance at gas platforms in the North Sea has reduced supply, and the shutdown of a cable bringing electricity from France have all played a part. The UK isn’t alone in experiencing surging energy prices. The cost of natural gas in the US has doubled since April, and thermal coal prices in Asia hit a record last week thanks to growing demand as the global economy begins to reopen after the pandemic.
Nonetheless, in August, Ofgem (the government’s regulator of utility companies) said that the price cap for household energy bills would rise by 12% on 1 October because of the jump in wholesale energy prices in the six months to the start of August.
That will add about 0.7 percentage points to inflation in October. And given gas and electricity prices have escalated since then, Ofgem will probably raise the price cap again when it amends it in April 2022.
We expect CPI inflation to peak at around 4.5% by the end of next year, then fall back to 2.0% by the end of 2022. Another sharp rise in energy price inflation in April would mean that CPI inflation would decrease a bit more slowly next year.
Regardless of what Ofgem does with the price cap in April, there are three reasons why we think the MPC will largely ignore the leap in energy prices:
- First, the disruption to some energy-intensive industries, such as fertilizer and steel manufacturers, and the knock-on effect to other industries will weigh on the economic recovery. The manufacturing sector is already struggling with labour and material shortages. Output was flat in July and is still 2.4% below its pre-crisis level, so further disruptions could easily cause activity to slip again.
- Second, most households already face a 1.25% tax rise in April next year, when the new Health and Social Care Levy kicks in. This could knock between 0.5% and 1.0% off consumer spending, although its impact on GDP will be offset by a boost in government spending. The rise in energy bills could dent consumer spending further, dampening demand for goods and services in the real economy. UK households and businesses spent about £55bn on gas and electricity in 2020.
Based on the moves in wholesale prices, Ofgem may increase the utility cap by 20% in April 2022. If consumers respond to this price increase as they would to a tax rise, it could reduce real GDP by about 0.3% over a year.
- Third, core inflation, which excludes food, fuel and energy prices and is the MPC’s preferred measure of underlying inflation, will still fall back quickly next year as the pandemic-related drivers of the current spike drop out of the annual comparison.
If anything, it seems more likely that the MPC will highlight the risks to the economic recovery from surging energy prices at its next meeting on Thursday than spend much time worrying about the upward pressure on headline inflation.
Should the committee signal danger to the economic recovery, there may be a reversal in some of the recent increases in ten-year gilt yields as financial markets reassess how quickly the MPC is likely to tighten policy.