With the cost of both energy and debt repayments rising, what can the UK government do? Take a targeted approach to support those in most need, writes João Sousa, Fraser of Allander deputy director.
War broke out in Iran and the broader Middle East just days before the Office for Budget Responsibility (OBR) presented its latest forecasts. At the time, we noted that depending on how long the war lasted for, the forecasts might well turn out to not be a great guide to the future – not through anyone’s fault, but just because it was a fast-moving situation.
Since then, things have escalated significantly. The Strait of Hormuz, a narrow passageway from the Persian Gulf to the Gulf of Oman and into the Indian Ocean, is effectively closed to oil and gas traffic. Around a fifth of the world’s trade in liquefied natural gas (LNG) and a quarter of oil transported by sea come through this small waterway, making it a crucial choke point for the world economy. Beyond this, significant infrastructure such as Ras Laffan in Qatar, the world’s largest LNG plant, was hit by Iranian strikes.
The effect of an energy price shock
Oil and gas prices have fluctuated significantly since 28 February, but what is undeniable is the increase in levels. Brent crude oil – the benchmark for Europe – is trading at around $100/barrel, nearly 40% higher than before the Iran War. Natural gas futures prices (UK National Balancing Point) are around 138 pence per therm, up 77% from the 78p/therm just before the war.
Energy price shocks have two main effects. The first is a direct effect on energy prices and therefore on inflation. Households in Great Brtiain using gas and electricity are protected in the UK in the very short-term, with the energy price cap already set until the end of June, until which time suppliers will have to manage the higher costs – they are expected to have hedged their supply, although big spikes can still lead to difficulties.
There are three important populations, however, which eagle-eyed readers will have noticed are not protected:
- Northern Ireland, which is not covered by Ofgem and has its own regulator. Northern Ireland has a high dependency on heating oil as well, which interacts with the following population:
- Households not on the conventional gas and electricity grid, for example those using oil for heating;
- Businesses, charities and government entities, whose tariffs are uncapped.
For GB households on the gas and electricity grid, any increase in price will come through in the price cap from July onwards. This provides a time buffer between now and any direct effects on bill increases, but clearly the consequences of the war could be very serious in terms of inflation for households depending on how long it lasts. If the conflict ends shortly, there may only be a small and short spike in the July-September price cap, which would also coincide with Summer, when less energy is used. If this is a more protracted affair, however, there might be significant pressure for the UK Government to provide broader protection.
There is also a secondary effect of this price spike, which is the cost of production of nearly everything. Energy and fuel are inputs into pretty much all the UK consumes to a smaller or greater extent. Goods need to be produced or transported, and even services rely on energy for their supply and often on travel. And with business usage uncapped, this brings up the price of goods and services, and is potentially a much longer-lasting effect on inflation. This is part of the effect that the Bank of England saw after 2022 with the energy price shock from Russia’s invasion of Ukraine, and the reason it acted to raise rates in its aftermath.
What should the Bank of England do?
One of the immediate effects of the price shock has been to delay what was a much-expected cut in Bank Rate, the Bank of England’s policy interest rate. This makes sense – inflation is likely to go up in the short-term, and the Bank has decided to wait and see if how long the conflict might last.
What its next steps might be is a different matter, and one which is likely to cause some debate and disagreement within the Monetary Policy Committee (MPC). If this turns out to be a very temporary blip, optimal monetary theory would tell the Bank to ‘see through’ the inflation spike and proceed as normal. The Bank cannot do anything about a supply shock of this kind.
But if it turns out to be a long-running war, the optimal response would be different. It would look much more like what the Bank has done since 2022 – raising rates to contain second-round effects and prevent the embedding of wage growth and broader domestic inflation taking hold.
This is the difficulty in conducting monetary policy in a fast-changing situation. In the classroom, we usually say “suppose there is a transitory shock” or “imagine there is a permanent shock”. But in real-time, it can be hard to know if it’s one or the other, and in cases like this it’s not possible at all.
This also explains the Bank’s wait-and-see approach. It’s essentially an option value of not making a decision at a time-pressured point when more information – only available through letting time pass – can lead to a more educated assessment of how long this situation is likely to last. But even with more time, it may well still be an educated guess to some extent by the time the next MPC meeting comes around.
Over the longer term, the Bank is likely to be wary of inflation expectations becoming de-anchored from the 2% target. While there have been good reasons for why inflation has stayed above target, it has now been several years since it has consistently hit its target. And the longer inflation stays above target, the harder it becomes to bring it back in line.
There is of course a worry that we might be in the worst of all worlds, with a supply shock causing high inflation at the same time as GDP growth is low. But if this turns out to be a prolonged shock, there may be little that can be done about the GDP implications – and the Bank may well have to keep rates higher than it would like to bring inflation back to target, much like what happened in the 1970s and early 1980s.
What should the UK Government do?
there is a very broad spectrum between doing nothing and a blanket approach of the kind taken by the short-lived Liz Truss government, which effectively capped the consumer price of energy at just above half the market rate.
In some sense, there is no textbook decision here. The higher energy prices will have to be paid by someone – the question is to what extent the cost should be shared between the Government (and ultimately taxpayers, either through immediate higher taxes or higher borrowing) or by energy users themselves.
There is a compelling case for protecting those on lower incomes, particularly given the very bad outcomes that can be caused by excessively rationing energy use. The UK is a cold country – heating is a necessity, particularly over the winter, and people having to agonise between putting food on the table or making one’s living space warm enough is not something anyone would want to see.
But there is a very broad spectrum between doing nothing and a blanket approach of the kind taken by the short-lived Liz Truss government, which effectively capped the consumer price of energy at just above half the market rate.
That was one of the broadest measures one can imagine, and it turned out to be exceptionally costly: £27 billion, even after a tightening of the scheme from April 2023 onwards. Its untargeted natured meant that the gains were pretty equally distributed across the population, which may sound good but it is not: it also meant that it subsidised many households which would have been able to withstand the shock without anywhere near as much help as they got from the government, and increased the cost of the scheme substantially.
One of the characteristics of the approach in the Autumn of 2022 was its blank-cheque nature: the UK Government committed itself to providing open-ended support, and although the total costs – including other payments to households and business support – ended up being around £62 billion, it could have been much higher had gas prices remained higher than they did.
The fiscal context is not as benign as before September 2022
Jeremy Hunt – Chancellor during the actual implementation of the Energy price Guarantee, although not when it was announced – recently wrote in The Times arguing for a more targeted approach to any support than the one he oversaw. The Prime Minister also seemed to indicate in his appearance at the Liaison Committee that he would seek to implement a less costly intervention that the previous government’s.
That’s good news in the sense that the open-ended blanket approach of 2022 was very costly. Given the time that has passed since then and the fact that we are a few months away from the peak of energy utilisation, the UK Government should be looking at ways of maximising the value-for-money of any support packages rather than rushing maximal support out. A heating oil grant for low-income households in rural areas was announced given the sudden increase in its price, but this was a small £53m fund.
But it is also important to note that the fiscal situation is in some ways considerably worse than it was when the 2022 support package was being considered, especially in terms of debt interest. Net borrowing has remained high since then, and it remains above 4% of GDP. Public sector net debt was then around 96% of GDP, and remains at a similar level, but the debt interest bill is now much higher: 3% of GDP, or £90 billion on net, according to the latest OBR forecast. That’s some 40% higher than it was in the March 2022 forecast.
And gilt yields have continued to climb in recent days as inflation expectations increase, making the debt interest situation worse. A quick back-of-the-envelope calculation using the OBR’s debt interest ready-reckoner, the latest market rates and inflation projections shows that this spike in interest rates could easily increase debt interest spending by £10-15 billion by 2029-30 – and that is before the UK Government has issued a penny in debt to pay for any additional support packages.
As an aside, it is important to note that although this is often portrayed as ‘wasted money’, debt interest is not optional. And it is not simply paying for past expenditure either; it’s a necessary condition of keeping capital market access. If you think debt interest is expensive, just imagine how much it might be if we broke with our international obligations.
Leave a Reply