Liz Truss’s first big move as PM has been to freeze the energy price cap for households for 2 years and do something similar for businesses, but only for 6 months. My take is that these moves will weaken demand in the economy compared with the position today but strengthen it compared with what it would be without the cap. Overall it does NOT mean the BoE will need to tighten more than otherwise.
There is some confusion about the implications for the economy and the Bank of England’s likely response. So lets try to work through it. Without a price cap households would have faced an average rise in energy bills of £1000 in October and probably an even larger increase next year (unless wholesale energy prices fall). That £1000 extra payment for energy would have reduced demand in the economy for other things but the money would have largely gone outside the economy to energy suppliers and companies (Russia, Norway, OPEC etc). So effectively a withdrawal of demand from the UK economy. In other words it would have been doing some of the Bank of England’s job for it, as the Bank tries to slow the economy and loosen the labour market.
With the price cap, people are in the same position as today (with energy prices about double last year but not going up again). So, on the face of it, the Bank of England might have more to do to slow the economy. But mitigating this are three points.
First, without the price cap, inflation would have risen to 15% or more from 10.1% in July. Imagine what a 15% inflation headline would do to wage demands. Nobody would be satisfied with less than a double-digit increase in wages. And, very importantly for the BoE’s thinking, inflation expectations would be ratcheted even higher.
Secondly, the support for businesses is only for 6 months, leaving many in a state of extreme uncertainty. There are reports of businesses facing energy price increases of threefold or even more without help. And for some, energy costs are a large part of overall costs. Perhaps this will be cleared up in coming days but talk of switching to targeted support to only ‘vulnerable’ businesses after 6 months suggests not. What business is going to hire or invest facing this uncertainty? This is very negative for the economy.
Thirdly, and perhaps more contentiously, there is so-called ‘Ricardian equivalence’. The cap is going to be paid for it seems with extra government borrowing rather than an additional windfall tax on energy companies or backloading it onto to energy customers when (as hoped) energy prices come down again. This is essentially announcing a big future bill for taxpayers. The theory of Ricardian equivalence argues that in these circumstances people will realise that taxes and/or borrowing costs will be higher in future because of the extra government debt and start saving ahead of time. The scale of the Ricardian equivalence effect is hard to know. I am sure it is not one-for-one. But it is likely that there will be some effect there, amounting to another dampener for demand.
Net impact on Boe thinking
So, what’s the net effect for the BoE? In my view the UK economy is likely already in recession due to the rise in energy prices so far. The weakening of demand as a direct result of the price cap, in line with points two and three above, suggests that the economy will weaken further, added to the effects of the BoE’s tightening working through. This suggests a moderate recession over the next year, raising unemployment and putting downward pressure on wages and inflation.
A more severe recession may have been avoided by the price cap (since the demand-dampening effect of higher energy prices would have born down on wages and inflation faster) but the avoidance of inflation rates of 15% or higher will make it easier to pull inflation expectations back down. Bear in mind too that the BoE was always expecting some government mitigation for future energy price rises so the only news Wednesday was that Truss’s move is more comprehensive than was anticipated a month ago.
What we still don’t know – and this applies to the US and Euro zone as well of course – is how much of a recession and rise in unemployment is necessary to bring inflation back to 2%. Central banks are likely to err on the hawkish side, rather than risk inflation becoming embedded. They are terrified of repeating the 1970s.
Is a price cap the right policy?
What about the view that it would have been better to let energy prices rise, incentivizing people to economise more on energy? Well – the risk that wages and inflation expectations ratchet up even higher is a powerful rejoinder already. But two further points. First, energy prices are already up a lot so there is a considerable incentive already there. Secondly, inflation of 15% or more would likely have been followed at some point by a big negative print for inflation when (hopefully) energy prices fall back. But this would be disruptive both for the economy and politics. How easy would it be to cut pensions for example?
On balance then, I think Truss’s move is the right one for the economy and does not put the BoE in a particularly bad place. I do think, however, that the approach to supporting business is going to need more work. Meanwhile, brace for the recession.