Whether you’re in meetings with us or reading the news, you will have been hearing a great deal about energy prices and inflation. Higher energy prices lead fairly intuitively to higher inflation, since oil and electricity are themselves constituents of the CPI basket. Somewhat less commonly grasped is how an energy shock diffuses through the wider economy by second-order effects, as energy is an input into nearly every good produced. So, to what extent do energy prices really drive inflation, and what does that tell us about the shock now unsettling global markets?
Helpfully, the ONS examined the CPI basket in 2022 to measure how energy costs are reflected in the basket’s constituent goods and services. Its metric, ‘energy intensity’, is the value of energy used in producing and supplying a product as a share of that product’s consumer price. It puts the intensity of the basket as a whole at 6.6%. At the divisional level, housing and household services (20.5%) and transport (17.5%) stand well clear of the rest, but largely because they contain energy directly, through household gas and electricity bills and motor fuels. Strip those direct components out and embedded intensity is far more modest: housing falls to 1.2% and restaurants, and hotels become the most energy-intensive division at just 2.7%.
Yet the energy-intensity map can be misleading, as what it captures is direct energy content that surges when wholesale prices spike and, just as reliably, falls back when they subside. It is a good guide to where a shock enters and where it will later unwind, but a poor guide to where overall inflation measures establish themselves. Persistence largely comes not from energy-heavy goods but from services and the wages behind them.
In a speech in March, MPC member Alan Taylor argued that today's shock has more in common with the mild disruption of 2011 than the severe one of 2022. The difference is in the starting conditions, as the 2022 energy shock hit an overheating economy with unemployment near a fifty-year low of 3.9% and pay growth around 7%. The tight labour market allowed the initial price shock to feed into unusually strong wage growth, helping to sustain inflation after energy prices had begun to fall. Regular pay growth was still running at a record 7.8% more than a year later, and inflation stayed above target long after energy prices themselves had fallen back. Today looks more like 2011, when unemployment was higher and pay growth weak, as the current unemployment rate is around 5%, pay growth around 3.5%, and the shock itself is smaller in magnitude. The prerequisites that would turn this current shock into a durable inflationary spiral are, for now, largely missing. That points, as Taylor puts it, to looking through the shock rather than leaning against it.
That said, the case for doing so holds only if the shock is genuinely single and mean-reverting. Monetary policy works with a lag of roughly eighteen months to two years, so it cannot offset a price rise that will have passed before a rate change fully takes effect. Inflation is measured year on year, so a one-off jump in energy prices lifts the annual rate for about twelve months, then drops out of the comparison. If prices then fall back, as is partially implied by the backwardation currently seen in energy markets, lower energy prices could pull inflation down. Inflation therefore returns to target unaided, so tightening would only impact the economy fully after the spike had faded, which could actually drive inflation below target in the medium term.
That reasoning depends entirely on energy prices reverting. The UK is particularly susceptible to wholesale gas prices, which have continued to rise given the lack of resolution to the closure of the Strait of Hormuz. If gas prices keep rising or simply remain high, which is somewhat likely given the inability of both sides of the current Middle East conflict to resolve it, there will be no or a limited favourable base effect for inflation. Since the start of the year, UK electricity and natural gas prices are up 87% and 124%, respectively, and the retail price cap will rise a further 4% in October with another increase already forecast for January. The longer that runs, the more likely households and firms are to revise up the inflation they expect and build it into wages and prices. While the wage-price inflation is partially curtailed through a loose labour market, it does not shut down the channel entirely. Expectations can still drift, workers retain some bargaining power, and firms retain some repricing power even in a loose labour market. A renewed or more prolonged shock could keep energy prices elevated long enough to work into inflation expectations, and once those drift, even a slack labour market offers only partial protection from a wage-price spiral.
So, perhaps counter-intuitively, the Bank of England will be monitoring the non-energy-intensive portion of the CPI basket to assess whether the price shock has migrated into wider pricing intentions.
Whether a shock proves transient or persistent shapes the path of Bank Rate and gilt yields, and with it, borrowing costs, investment returns and medium-term financial plans. Translating that macro picture into a clear view on rates and yields, so debt, investment, and planning decisions are positioned for the outlook rather than caught out by it, is precisely what our forecasting service aims to accomplish. If you would like to learn more about how we can help your organisation, please contact fwatson@arlingclose.com.
-960x640.webp&w=3840&q=75)
