Rishi Sunak began the year with a promise to cut inflation in half; a promise for which he was rightly mocked, because Sunak himself has little control over what happens to inflation. That responsibility lies with the Bank of England, which is in charge of monetary policy tools such as interest rates and quantitative easing, and with the wider economy, which may well cut inflation by falling into recession. It’s also not the most ambitious target, because inflation is expected to remain in double digits (predictions are around 10.5 per cent) when the Office for National Statistics (ONS) releases December’s data later this morning (18 January). Inflation at 5.25 per cent would still be more than double the Bank of England’s target.
The reason Sunak couldn’t promise anything more ambitious is that while wholesale energy prices – the prime driver behind recent rises in inflation – have fallen recently, the energy sector is clearly signalling that energy will continue to remain expensive for the foreseeable future.
Anders Opedal, the chief executive of the Norwegian oil producer Equinor, told the BBC that it’s unlikely energy prices will ever drop back to the halcyon days of pre-Covid, when many customers paid less than Ofgem’s price cap of £1,300 a year (at the moment it’s £2,500 and will rise to £3,000 in April). Opedal said there had been a “kind of re-wiring of the whole energy system in Europe, particularly after the gas from Russia was taken away”, and added that the cost of increasing supply from renewables will help to keep prices high.
Opedal’s comments may be surprising to some: they come after recent steep falls in gas prices which, according to analysts at Goldman Sachs, mean the cost of the government’s Energy Price Guarantee scheme will be just £3.5bn this year, “meaningfully lower” than the £12.8bn forecast by the Office for Budget Responsibility in November.
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But they echo the findings of the energy consultancy Cornwall Insight, which published data yesterday (17 January) suggesting that pre-pandemic prices “may, at least for the next decade, be a pipedream” as producers (and governments) focus on filling the gap left by Russian fuel, and increase their energy security by moving production closer to home.
High but stable energy prices would not add to inflation in the long term, because inflation is a measure of how much prices are changing – so if energy prices remain high but don’t rise, inflation should start to fall. The problem comes when there is volatility in the price of energy, which then affects the inflation figure and introduces volatility to other prices.
The UK is particularly vulnerable to volatility in gas prices. If an unusually cold winter increases demand, or a mild winter unexpectedly lowers demand, or an autocratic petrostate begins a land war in Europe, wholesale “spot” prices change wildly, and because the UK has comparatively little capacity to store gas, it has less capacity to absorb these changes. We are able to store about 9 terawatt hours, compared with about 250TWh in Germany, 200TWh in Italy and around 140TWh in France. That means it’s harder for us to buy gas during periods that prices are lower and use it up when prices are higher, which is why the UK imported 118.3TWh of gas in the third quarter of last year.
“The difference in price that people pay through bills is going to [remain] higher than the traditional norm,” I was told by Kate Mulvany, a senior consultant at Cornwall Insight. She pointed out that the price of energy affects all parts of the “basket of goods” the ONS uses to calculate inflation. “Because of how much of people’s wages go towards energy costs, that’s very significant. The amount of manufacturing costs that are related to energy, that’s going to continue, public sector budgets, hospitals, community centres, swimming pools, they all need lighting and heat… So although the outlook is falling prices, compared with the very high recent prices, they’re not likely to return to historical norms. It will still, in all likelihood, have an effect on what we consider to be normal allocation of wages, and normal running costs.”
The good news is that, according to Cornwall Insight’s forecast, the price of power will fall from £250 per megawatt hour this winter to under £100 per MWh by 2030. But we are unlikely, during this decade, to see the prices we did in 2021, when power cost just £50 per MWh. And in the meantime, volatility in the market will keep contributing to inflation, point out analysts at Goldman Sachs, who said in a recent note that, thanks to energy prices, “we continue to expect inflation to remain sticky through [the first half of] 2023”.
To an extent, then, Sunak was describing what’s possible: with energy prices remaining high until at least the end of the decade and the UK’s inability to store gas meaning volatility will keep having a disproportionate effect on prices, the Bank of England’s 2 per cent inflation target looks a long way off. Cutting it in half may be the most we can hope for.
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