By Edward Attard
This week, Liz Truss has taken office as Britain’s new prime minister, inheriting an economy that is forecast to go into a long recession later this year, with inflation at a 40-year high and limits on the options available for getting growth going again. So, what might we expect over the next few months following her appointment?
Along the campaign trail and indeed, in her acceptance speech, Truss pledged to prioritise soaring energy bills for households and businesses, with the current working plan being to subsidise the wholesale cost of gas, either through directly compensating energy companies for losses they incur as a result of price freezes, or by providing energy companies with state-backed commercial loans that could then be clawed back from households and businesses over many years. Effectively, both approaches allow suppliers to cap the price of energy, at least temporarily, and effectively transfer the cost from households and businesses to the government. In addition, Truss has also promised tens of billions of pounds of tax cuts for lower income households to help through the cost-of-living crisis. Truss’s allies have suggested that a household package would cost £90bn, with an estimated £40bn-£60bn for the business element, though this has yet to be finalised.
Under normal circumstances, wholesale gas prices are used to set the price of all electricity, irrespective of how it is generated. This is not a problem when the marginal cost of gas moves in line with other sources of electricity. However, over the past 18 months, the wholesale price of natural gas has increased ten-fold. In the UK, roughly 40% of electricity comes from gas. Last month, Ofgem (The Office of Gas and Electricity Markets) announced that the energy price cap in the UK is set to jump by 80% in October to better reflect market dynamics.
Should a new UK government freeze energy prices prior to this shift, one of the implications is that the measured rate of inflation may be lower than it otherwise would have been, potentially reducing the headline figure by somewhere in the region of 3.5p.p. This means that inflation may rise from 10.1% in July to a peak of 11%, rather than roughly 14.5% toward the end of the fourth quarter. This in turn would have some secondary benefits for the economy, as it may lower the cost of government debt payments on inflation-linked gilts and may also go some way to reducing the possible upside risks from second round effects to higher inflation. As a broad rule of thumb, a 1% increase in RPI inflation adds around £5bn to the annual interest bill on government debt.
This reduced headline inflation would help households and businesses as it means real incomes would not fall as far, and economic growth going into 2023 would be supported to some degree. The issue, however, is that these measures alone will likely not provide enough support to prevent a recession in the UK, though it may be the case that these measures will limit the depth and length of that recession. Another key consideration in this discussion is that, to the extent that more is done on the fiscal side, say in the form of tax cuts, it is likely the Bank of England is going to have to do more on the monetary side to counter further underlying inflation surprises. So, the expectation is that looser fiscal policy that supports the economy may need to come alongside even tighter monetary policy.
As welcome as these measures are to address what is turning out to be the most significant UK consumer crisis of our lifetime, there does need to be an acknowledgment from the Truss government of the resultant strain to the UK’s deficit and debt levels, and it is imperative that the package that is announced by the government does come alongside some signals or commitments of fiscal discipline over the long term in order to maintain some stability in financing conditions. Similarly, whilst a price freeze would buy the government time, if higher wholesale gas prices are here to stay, the system of domestic energy pricing in the UK would need to be reformed to better reflect the average marginal cost of electricity production from all sources. As it stands, there remains the risk that these measures merely kick the issue into next year, when the extent of the support package is exhausted or increased.