Constituent policy

Energy policy complicates life for the Bank of England

  • New energy price package provides relief for now, but risks fueling inflation later
  • Does this mean a conflict between fiscal and monetary policies?

According to the chief British economist of Capital Economics, Paul Dalethe new energy price support package saved the Bank of England from blushing. Goldman Sachs warned last month that inflation could top 20% in the absence of lower energy prices – 18% above the UK’s inflation target.

The outlook now looks considerably brighter. Capital Economics expects inflation to peak at “just” 11.5% thanks to energy bill freezes. Still, Dales warns that the generous support package “will probably just mean that inflation is higher than otherwise in the future.” Herein lies one of the paradoxes of fiscal injection: how can a policy both decrease and increase inflation in the UK?

In August (before the announcement of the energy support package), the bank of england warned that inflationary pressures had intensified in the UK. This is largely due to a huge increase in wholesale gas prices and energy costs, as my chart shows. Consulting company Snapshot of Cornwall, expected energy bills to top £5,000 in the absence of government support, pushing inflation even higher. By capping average household energy bills at £2,500 (plus ‘equivalent’ support for businesses), the new policy is pouring cold water on previously searing energy prices. Economists at Panmure Gordon estimate the measures could reduce inflation by up to 6% and bring forward the six-month peak.

But energy prices are not the only contributors to inflation: the BoE has also expressed concern about “domestic engines”. At the August Monetary Policy Committee meeting, the Bank explained that “although much less responsible for the rise in headline inflation, domestic inflationary pressures have also increased and are expected to remain strong in the near term. The labor market remains tight and domestic cost and price pressures are high.

Although the energy price support program cools the energy price component of inflation, it could intensify these domestic pressures in the longer term. Lower inflation will ease the pressure on household finances, keeping consumption and confidence high. Some of these side effects are positive: Pantheon Macroeconomics predicts that the resulting rise in real household disposable income will be large enough to narrowly avoid a recession in the UK. But the impact on the price level could turn out to be less welcome.

Deutsche Bank senior economist Sanjay Raja argues the package will raise both labor market pressures and inflation expectations. In the absence of a recession, businesses and consumers could continue to anticipate high inflation and adjust their wage and price demands accordingly. As a result, he expects the Bank to hike to a terminal rate of 4% in a bid to bring inflation back to target – 150 basis points above its previous call.

Although economists agree that higher interest rates will be needed, there is less consensus on their level. Capital saving agree rates could push to 4%, although Pantheon Macroeconomics argues for a lower terminal rate of 2.75%. But informed observers note that these figures are not very different from the implied market rates published by the Bank of England in August (3%) – even before the announcement of the new energy support program.

There are also signs that the government is taking a more dovish approach to the BoE. Truss had previously hinted at a change in the Bank of England’s mandate, and Kwasi Kwarteng (now chancellor) argued last month that “something has clearly gone wrong” with the UK’s inflation outlook. But earlier in September, Kwarteng said in the FT that a Truss government “would remain fully committed to the independence of the Bank of England and the important work it has in the months ahead to bring down inflation”. He added that “we believe that coordination between monetary policy and fiscal policy is crucial”. The conflict between monetary policy and fiscal policy seems overdone – for now.