Category: Economics: Ch 11

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Soaring gas prices (updated 1/10/22)

International wholesale gas prices have soared in recent months. This followed a cold winter in 2021/22 across Europe, the bounceback in demand as economies opened up after COVID and, more recently, pressure on supplies since the Russian invasion of Ukraine and the resulting restricted gas supplies from Russia. The price of gas traded on the UK wholesale market is shown in Chart 1 (click here for a PowerPoint). Analysts are forecasting that the wholesale price of gas will continue to rise for some time. The higher price of gas has had a knock-on effect on wholesale electricity prices, as gas-fired power stations are a major source of electricity generation and electricity prices.

In the UK, domestic fuel prices were capped by the regulator, Ofgem. The cap reflected wholesale prices and was designed to allow electricity suppliers to make reasonable but not excessive profits. The cap was adjusted every six months, but this was been reduced to three months to reflect the rapidly changing situation. Prices are capped for both gas and electricity for both the standing charge and the rate per kilowatt hour (kWh). This is illustrated in Chart 2 (click here for a PowerPoint).

The effects of the cap were then projected in terms of a total annual bill for a typical household consuming 12 000 kWh of gas and 2900 kWh of electricity. Chart 3 shows the typical fuel bill for the last four price caps and, prior to the mini-Budget of 23 September, the projected price caps for the first and second quarters of 2023 based on forecasts at the time of wholesale prices (click here for a PowerPoint). As you can see, wholesale gas and electricity prices account for an increasing proportion of the total bill. The remaining elements in cost consist of profits (1.9% assumed), VAT (5%), operating costs, grid connection costs and green levies (around £153). The chart shows that, without government support for prices, the price cap would have risen by 80.6% in October 2022 and was projected to rise by a further 51% in January 2023 and by another 23% in March 2023. If this were to have been the case, then prices would have risen by 481% between the summer of 2021 and March 2023.

This was leading to dire warnings of extreme fuel poverty, with huge consequences for people’s health and welfare, which would put extra demands on an already stretched health service. Many small businesses would not be able to survive the extra fuel costs, which would lead to bankruptcies and increased unemployment.

Future wholesale gas prices

Energy market analysts expect wholesale gas prices to remain high throughout 2023, with little likelihood that gas supplies from Russia will increase. Some European countries, such as Germany, have been buying large amounts of gas to fill storage facilities before winter and before prices rise further. This has added to demand.

The UK, however, has only limited storage facilities. Although it is not an importer of gas from Russia and so, in one sense, storage facilities are less important at the current time, wholesale gas prices reflect international demand and supply and thus gas prices in the UK will be directly affected by an overall global shortage of supply.

What would have been the response to the projected rise in gas prices? Eventually demand would fall as substitute fuels are used for electricity generation. But demand is highly inelastic. People cannot readily switch to alternative sources of heating. Most central heating is gas fired. People may reduce consumption of energy by turning down their heating or turning it off altogether, but such reductions are likely to be a much smaller percentage than the rise in price. Thus, despite some use of other fuels and despite people cutting their energy usage, people would still end up spending much more on energy.

Over the longer term, new sources of supply of gas, including liquified natural gas (LNG), may increase supply. And switching to green energy sources for electricity generation, may bring the price of electricity back down and lead to some substitution been gas and electricity in the home and businesses. Also improved home insulation and the installation of heat pumps and solar panels in homes, especially in new builds, may reduce the demand for gas. But these changes take time. Chart 4 illustrates the situation (click here for a PowerPoint).

Both demand and supply are relatively inelastic. The initial demand and supply curves are D1 and S1. Equilibrium price is P1 (point a). There is now a fall in supply. Supply shifts to S2. With an inelastic demand, there is a large rise in price to P2 (point b).

Over two or three years, there is a modest fall in demand (as described above) to D2 and a modest rise in supply to S3. Price falls back somewhat to P3 (point c). Over a longer period of time, these shifts would be greater and the price would fall further.

Possible policy responses

What could the government do to alleviate the problem? Consensus was that the new Conservative Prime Minister, Liz Truss, and her Chancellor, Kwasi Kwarteng, would have to take radical measures if many households were to avoid severe hardship and debt. One proposal was to reduce VAT on domestic energy from 5% to zero and to cut green levies. Although this would help, it would make only a relatively small dent in people’s rising bills.

Another proposal was to give people cash payments to help with their bills. The more generous and widespread these payments, the more costly they would be.

One solution here would be to impose larger windfall taxes on oil and gas producers (as opposed to retailers). Their profits have soared as oil and gas prices have soared. Such a move is generally resisted by those on the right of politics, arguing that it could discourage investment in energy production. Those on the centre and left of politics argue that the profits are the result of global factors and not because of wise business decisions by the energy producers. A windfall tax would only take away these excess profits.

The EU has agreed a tax on fossil fuel companies’ surplus profits made either this year or next. It is also introducing a levy on the excess revenues that other low-cost power producers make from higher electricity prices.

Another proposal was to freeze retail energy prices at the current or some other level. This would make it impossible for energy suppliers to cover their costs and so they would have to be subsidised. This again would be very expensive and would require substantially increased borrowing at a time when interest rates are rising, or increased taxation at a time when people’s finances are already squeezed by higher inflation. An alternative would be to cap the price North Sea producers receive. As around half of the UK’s gas consumption is from the North Sea, this would help considerably if it could be achieved, but it might be difficult to do so given that the gas is sold onto international markets.

One proposal that was gaining support from energy producers and suppliers is for the government to set up a ‘deficit fund’. Energy suppliers (retailers) would freeze energy prices for two years and take out state-backed loans from banks. These would then be paid back over time by prices being capped sufficiently high to cover costs (which, hopefully, by then would be lower) plus repayments.

Another policy response would be to decouple electricity prices from the wholesale price of gas. This is being urgently considered in the EU, and Ofgem is also consulting on such a measure. This could make wholesale electricity prices reflect the costs of the different means of generation, including wind, solar and nuclear, and would see a fall in wholesale electricity prices. At the moment, generators using these methods are making large profits.

The government’s response

On September 23, the government held a mini-Budget. One of its key elements was a capping of the unit price of energy for both households and firms. The government called this the Energy Price Guarantee. For example, those households on a variable dual-fuel, direct-debit tariff would pay no more than 34.0p/kWh for electricity and 10.3p/kWh for gas. Standing charges are capped at 46p per day for electricity and 28p per day for gas. These rates will apply for 2 years from 1/10/22 and should give an average annual household bill of £2500.

Although the government has widely referred to the ‘£2500 cap’, it is the unit price that is capped, not the annual bill. It is still the case that the more you consume, the more you will pay. As you can see from Chart 3, the average £2500 still represents an average increase per annum of just over £500 per household and is almost double the cap of £1277 a year ago. It will thus still put considerable strain on many household finances.

For businesses, prices will be capped for 6 months from 1 October at 21.1p per kWh for electricity and 7.5p per KWh for gas – considerably lower than for domestic consumers.

The government will pay subsidies to the retail energy companies to allow them to make sufficient, but not excess, profit. These subsidies are estimated to cost around £150 billion. This will be funded by borrowing, not by tax increases, with the government ruling out a windfall tax on North Sea oil and gas extracting companies. Indeed, the mini-Budget contained a number of tax reductions, including scrapping the 45% top rate of income tax, cutting the basic rate of income tax from 20% to 19% and scrapping the planned rise in corporation tax from 19% to 25%.

Articles

Data

Questions

  1. Why are the demand and supply of gas relatively inelastic with respect to price?
  2. Why are the long-run elasticities of demand and supply of gas likely to be greater than the short-run elasticities?
  3. Find out how wholesale electricity prices are determined. Is there a case for reforming the system and, if so, how?
  4. Identify ways in which people could be protected from rising energy bills.
  5. Assess these different methods in terms of (a) targeting help to those most in need; (b) economic efficiency.
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Looming stagflation


Aggregate demand has been booming as the world bounces back from the pandemic. At the same time, aggregate supply is severely constrained. These supply constraints are making potential national income smaller – at least temporarily. The result is that many countries are heading for recession.

At the same time, supply constraints are causing prices to rise, especially energy and food prices. This cost-push inflation is made worse by the rises in aggregate demand.

The result is ‘stagflation’ – a recession, or stagnation, accompanied by high inflation. In the UK, the latest Bank of England Monetary Policy Report forecast that by the end of 2022, CPI inflation would be 13.1% and that in 2023, real GDP would fall by 1.5%.

This effect of an adverse supply shock accompanied by relatively buoyant aggregate demand (at least initially) can be illustrated with an aggregate demand and supply diagram. The supply shock is illustrated by an upward shift to the left of the short-run aggregate supply curve (SRAS). (If the shock is a direct rise in prices, then it can be seen as a vertical upward shift. If it is a fall in the total amount supplied, then it can be seen as a horizontal leftward shift.) In the diagram, aggregate supply shifts from SRAS1 to SRAS2. The price level rises from P1 to P2. If costs go on rising or supply goes on falling then the curve will go on shifting upwards to the left.

If the government responds by increasing benefits or reducing taxes, then, other things being
equal, aggregate demand will rise. In the diagram, the AD curve will shift to the right, e.g. from AD1 to AD2. Real GDP only falls to Y3 not Y2. However, the price level rises further: from P2 to P3.

Why has aggregate supply fallen?

There are several factors that have contributed to the fall in aggregate supply/rise in costs.

  • Stretched supply chains, which had been adversely affected by Covid. Congestion at container ports has led to delays, with warehouses and shops being short of stock.
  • Labour shortages, with many people not returning to the labour force after being laid off or furloughed, or only returning part time, leaving firms needing more people. The problem has been particularly acute in the UK, with many EU citizens having returned to the EU after Brexit and the UK having to rely increasingly on staff from outside the EU.
  • The war in Ukraine. This has had a major impact on the supply of natural gas and oil. The war has also led to a fall in grain and other food supplies from Ukraine, as ports have been blockaded and there have been disruptions to planting and harvesting.
  • Climate change is causing more severe weather events, such as droughts in Europe and western USA. The droughts of 2022 will compound the problem of food shortages and food price inflation.
  • In the UK, Brexit costs, such as increased administrative burdens and difficulties in both exporting and importing, have dampened production and hence adversely impacted on aggregate supply.
  • Increased industrial action. As the cost of living soars, unions are demanding pay increases to match the rise in the cost of living. Pay rises further increase firms’ costs – and the bigger the pay rises, the bigger the rise in costs.

The problem with a fall in aggregate supply is that it reduces real GDP. People as a whole are poorer. To use a common analogy, the national ‘pie’ has shrunk. Giving everyone a bigger knife and fork (i.e. a rise in nominal aggregate demand) will not make people better off. It just compounds the problem of rising prices, as the diagram shows.

In the short term, with GDP shrinking, there is a major issue of distribution. If the poor are to be given help so that they are not made even poorer, then other people will have been made worse off. In other words, their nominal incomes must rise more slowly than prices.

Monetary policy

Central banks generally have a mandate of keeping inflation close to 2% over the medium term. Their levers are changes in interest rates, underpinned by changes in the money supply – in extreme times by quantitative easing (creating money by buying assets with newly created money) or quantitative tightening (withdrawing money from the economy by selling assets). Central banks, faced by soaring inflation, have been raising interest rates. The Fed has recently raised the Federal Funds rate by 0.75 percentage points (75 basis points) and the Bank of England and the European Central Bank by 0.5 percentage points (50 basis points).

Raising interest rates reduces inflation by dampening aggregate demand. In the diagram, the AD curve shifts to the left (or shifts to the right less quickly). This will dampen inflation, as falling real demand will force firms to cut prices. But it will also force them to cut output and employment, thereby worsening the recession.

Central banks recognise this dilemma, but also recognise that if inflation is not brought rapidly under control, it could spiral upwards, with wages and prices chasing each other in a wage–price spiral, which only gets worse as inflationary expectations rise. The short-term pain of falling real income is a price worth paying for getting inflation under control.

Fiscal policy

In the short term, there is little that fiscal policy can do to raise real GDP. The focus, as it was during the pandemic, must therefore be in providing relief to those most in need.

In the UK, the energy price cap set by Ofgem will see likely energy bills for the typical household quadruple in just a year, from a little over £1000 per annum at January 2021 prices to over £4200 in predicted January 2023 prices. These higher prices partly reflect rising wholesale energy costs and partly the need for energy companies, in a process known as ‘backwardation’, to recoup hedging costs they have incurred so as not to be forced out of business.

Relief for consumers can be in various forms. For example, the government could pay subsidies to energy suppliers to cap prices at a lower level, perhaps just for the poorest households. Or it could pay grants to help people with their bills. Again, these could be targeted to the poorest families, or paid on a sliding scale according to income. Or VAT on gas and electricity could be scrapped.

Generally the more people are entitled to help, the more expensive it is for the government and hence the less generous the help per family is likely to be.

Then there is the question of whether such measures should be accompanied by a rise in broadly-based tax, such as income tax, or whether the government should borrow more, which would be likely to push up interest rates and increase the cost of servicing government debt.

One topic of debate in the Conservative leadership contest is whether taxes should be cut to help people struggling with the cost of living. Whilst such a policy, if carefully targeted to investment, might increase aggregate supply over the longer term, in the short term it will increase aggregate demand and will add to inflationary pressures.

Targeting tax cuts to the poor is difficult. Cutting income tax rates has the opposite effect. The rich pay more income tax than the poor and will benefit most from a cut in rates. An alternative is to raise personal allowances. This will provide a bigger percentage help to income taxpayers on lower incomes, but provides no help at all for the poorest people who currently pay no income tax.

Conclusion

The supply shocks are making countries poorer. The focus in the short term, therefore, needs to be on income distribution and how to help those suffering the most.

To end on a note of optimism: the energy shocks are causing governments to invest in alternative sources, such as wind, solar and nuclear. When these come on line, it is expected that energy prices will fall.

As far as overall inflation is concerned, although the Bank of England is forecasting CPI inflation of 13.1% by Q4 2022, it is also forecasting that this will have fallen to 5.5% by Q4 2023 and to just 0.8% by Q3 2024. Fingers crossed.

Articles

Reports etc.

Questions

  1. What are the most efficient policies for helping those in energy poverty?
  2. Why is inflation forecast to fall later in 2023?
  3. What determines the shape of the short-run aggregate supply curve?
  4. What government policies would support (a) labour productivity; (b) investment?
  5. How might the market solve the problem of supply shortages?
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A Spring dose of fiscal policy

On March 23, Rishi Sunak, the UK’s Chancellor of the Exchequer, delivered his Spring Statement, in which he announced changes to various taxes and grants. These measures were made against the background of rising inflation and falling living standards.

CPI inflation, currently at 6.2%, is still rising and the Office for Budget Responsibility forecasts that inflation will average 7.4% this year. The poor spend a larger proportion of their income on energy and food than the rich. With inflation rates especially high for gas, electricity and basic foodstuffs, the poor have been seen their cost of living rise by considerably more than the overall inflation rate.

According to the OBR, the higher inflation, by reducing real income and consumption, is expected to reduce the growth in real GDP this year from the previously forecast 6% to 3.8% – a much smaller bounce back from the fall in output during the early stages of the pandemic. Despite this growth in GDP, real disposable incomes will fall by an average of £488 per person this year. As the OBR states:

With inflation outpacing growth in nominal earnings and net taxes due to rise in April, real living standards are set to fall by 2.2 per cent in 2022/23 – their largest financial year fall on record – and not recover their pre-pandemic level until 2024/25.

Fiscal measures

The Chancellor announced a number of measures, which, he argued, would provide relief from rises in the cost of living.

  • Previously, the Chancellor had announced that national insurance (NI) would rise by 1.25 percentage points this April. In the Statement he announced that the starting point for paying NI would rise from a previously planned £9880 to £12 570 (the same as the starting point for income tax). This will more than offset the rise in the NI rate for those earning below £32 000. This makes the NI system slightly more progressive than before. (Click here for a PowerPoint of the chart.)
  • A cut in fuel duty of 5p per litre. The main beneficiaries will be those who drive more and those with bigger cars – generally the better off. Those who cannot afford a car will not benefit at all, other than from lower transport costs being passed on in lower prices.
  • The 5% VAT on energy-saving household measures such as solar panels, insulation and heat pumps will be reduced to zero.
  • The government’s Household Support Fund will be doubled to £1bn. This provides money to local authorities to help vulnerable households with rising living costs.
  • Research and development tax credits for businesses will increase and small businesses will each get another £1000 per year in the form of employment allowances, which reduce their NI payments. He announced that taxes on business investment will be further cut in the Autumn Budget.
  • The main rate of income tax will be cut from 20% to 19% in two years’ time. Unlike the rise in NI, which only affects employment and self-employment income, the cut in income tax will apply to all incomes, including rental and savings income.

Fiscal drag

The Chancellor announced that public finances are stronger than previously forecast. The rapid growth in tax receipts has reduced public-sector borrowing from £322 billion (15.0 per cent of GDP) in 2020/21 to an expected £128 billion (5.4 per cent of GDP) in 2021/22, £55 billion less than the OBR forecast in October 2021. This reflects not only the growth in the economy, but also inflation, which results in fiscal drag.

Fiscal drag is where rises in nominal incomes mean that the average rate of income tax rises. As tax thresholds for 2022/23 are frozen at 2021/22 levels, a greater proportion of incomes will be taxed at higher rates and tax-free allowances will account for a smaller proportion of incomes. The higher the rate of increase in nominal incomes, the greater fiscal drag becomes. The higher average rate of tax drags on real incomes and spending. On the other hand, the extra tax revenue reduces government borrowing and gives the government more room for extra spending or tax cuts.

The growth in poverty

With incomes of the poor not keeping pace with inflation, many people are facing real hardship. While the Spring Statement will provide a small degree of support to the poor through cuts in fuel duty and the rise in the NI threshold, the measures are poorly targeted. Rather than cutting fuel duty by 5p, a move that is regressive, removing or reducing the 5% VAT on gas and electricity would have been a progressive move.

Benefits, such as Universal Credit and the State Pension, are uprated each April in line with inflation the previous September. When inflation is rising, this means that benefits will go up by less than the current rate of inflation. This April, benefits will rise by last September’s annual inflation rate of 3.1% – considerably below the current inflation rate of 6.2% and the forecast rate for this year of 7.4%. This will push many benefit recipients deeper into poverty.

One measure rejected by Rishi Sunak is to impose a temporary windfall tax on oil companies, which have profited from the higher global oil prices. Such taxes are used in Norway and are currently being considered by the EU. Tax revenues from such a windfall tax could be used to fund benefit increases or tax reductions elsewhere and these measures could be targeted on the poor.

Articles

OBR data and analysis

Questions

  1. Are the changes made to national insurance by the Chancellor progressive or regressive? Could they have been made more progressive and, if so, how?
  2. What are the arguments for and against cutting income tax from 20% to 19% in two years’ time rather than reversing the current increases in national insurance at that point?
  3. What will determine how rapidly (if at all) public-sector borrowing decreases over the next few years?
  4. What are automatic fiscal stabilisers? How does their effect vary with the rate of inflation?
  5. Examine the public finances of another country. Are the issues similar to those in the UK? Recommend fiscal policy measures for your chosen country and provide a justification.
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Rise in the cost of living
Part 2: UK Government response

As we saw in Part 1, households are seeing a rise in the cost of living, which is set to accelerate. Inflation in the year to January 2022, as measured by the Consumer Prices Index (CPI), was 5.5%, the highest rate for over 30 years, and it is expected to reach more than 7 per cent by April. This has put great pressure on household budgets, with wage rises for most people being below the rate of price inflation. The poor especially have been hard hit, with many struggling to meet soaring energy, food and transport prices and higher rents.

In Part 2 we look at the UK government’s response to the situation, a similar response to that in many other countries.

Effects on government finances

The Chancellor, Rishi Sunak, has stated that the government understands the pressures families are facing with the cost of living. However, rising interest rates mean that it will cost the Treasury considerably more to service the UK’s national debt of more than £2tn.

Interest payments on index-linked debt are calculated using an alternative measure of inflation, the retail prices index (RPI), which is running at 7.8%, considerably higher than anticipated in last October’s Budget. It is now projected that central government spending on debt interest this financial year will come in at around £69bn, some £11bn higher than the £58bn forecast in the October 2021 Budget and £27bn above the £42bn forecast in the March 2021 Budget.

In addition, it is expected that the latest rise in CPI will increase the chances of the Bank of England raising interest rates and thereby further increasing the costs of servicing national debt. If this is the outcome when its Monetary Policy Committee meets next month, then it would be the third successive time interest rates have been raised.

There is also concern that this, in addition to the direct effects of higher costs, will push more firms towards insolvency. It is argued that if government wanted to prevent this, it would need to cut business taxes in order to boost investment and productivity and to allow businesses to provide annual wage rises that are affordable.

Monetary policy

The Bank of England’s traditional response to rising inflation is to raise interest rates, which it has done this twice in the past few months. This means that people who have borrowed money could see their monthly payments go up, especially on mortgages tied to Bank Rate.

An aim of this policy is to make borrowing more expensive resulting in people spending less. As a result, they will buy fewer things, and prices will stop rising as fast. However, when inflation is caused by external forces, this might have a limited effect on prices and would put a further squeeze on household budgets.

Fiscal policy

Alternatively, the government might choose to cut taxes for consumers on items whose prices are rising quickly. It is taking some measures to reduce the impact of energy price rises. For example, the Treasury has announced that it would provide millions of households with up to £350 to help with their rising energy bills and in April the lowest-paid will see the National Living Wage rise by 6.6%, which is higher than the current inflation rate.

The chief economist of the British Chambers of Commerce has said that tightening monetary policy too quickly risks undermining confidence and the wider recovery, arguing that more needs to be done to limit the unprecedented rise in costs facing businesses, including financial support for those struggling with soaring energy bills and delaying April’s national insurance rise.

Conclusion

Rising inflation affects all our living standards. It a global issue with causes beyond government control.

Rising prices together with planned tax increases mean that real average take-home pay is likely to fall over the coming year. The extra energy costs and tax rises will force families to make savings elsewhere, meaning business revenues may fall, and the economic recovery could be negatively impacted.

However, it is those on low incomes that tend to find it hardest to cope with the rising cost of living. Those impacted the most will be faced with difficult decisions over the coming months as they try to cope with falling real incomes. With food price inflation expected to rise further, a likely rise in interest rates and a further increase in the energy price cap in October, these tough decisions are set to get harder for poorest households in the economy.

Articles

See articles in Part 1

Podcast

Questions

    These questions are based on the podcast.

  1. What elements are there in household energy prices? Which element has gone up most?
  2. What are the arguments for and against the government delaying the rise in the rate of national insurance by 1.25 percentage points?
  3. What can be done to help people on modest earnings who earn just too much to receive benefits?
  4. Are government loans to help people with higher bills a good idea?
  5. What are the advantages and disadvantages of removing VAT on domestic energy?
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Rise in the cost of living
Part 1: What are the distributional consequences?

Households are expected to see further rises in the cost of living after the annual inflation rate climbed for a 13th month to its highest point in almost 30 years. This will put further pressure on already stretched household budgets. The increase reflects a bounceback in demand for goods and services after lockdowns, when prices fell sharply. It also reflects the impact of supply-chain disruptions as Covid-19 hit factory production and global trade.

The biggest concern, however, is the impact it will have on those already hard-pressed families across the UK. According to official figures, prices are rising at similar rates for richer and poorer households. However, household income levels will determine personal experiences of inflation. Poorer households find it harder to cope than richer families as essentials, such as energy and food, form a larger proportion of their shopping basket than discretionary items. On average the lowest-income families spend twice as much proportionately on food and housing bills as the richest. So low-income households, if they are already spending mainly on essentials, will struggle to find where to cut back as prices rise.

Latest Inflation figures

Latest figures from the ONS show that the Consumer Prices Index (CPI) rose by 5.5% in the year to January 2022, with further increases in the rate expected over the next couple of months. In measuring inflation, the ONS takes a so-called ‘basket of goods, which is frequently updated to reflect changes in spending patterns. For example, in 2021, hand sanitiser and men’s loungewear bottoms were added, but sandwiches bought at work were removed.

Annual CPI inflation is announced each month, showing how much the weighted average of these prices has risen since the same date last year. The weighted average is expressed as an index, with the index set at 100 in the base year, which is currently 2015.

Consumers would not normally notice price rises from month to month. However, prices are now rising so quickly that it is clear for everyone to see. What is more, average pay is not keeping up. There are workers in a few sectors, such as lorry drivers, who are in high demand, and therefore their wages are rising faster than prices. But the majority of workers won’t see such increases in pay. In the 12 months to January, prices rose by 5.5% on average, but regular pay, excluding bonuses, on average rose by only 4.7%, meaning that they fell by 0.8% in real terms.

The Bank of England has warned that CPI inflation could rise to 7% this year and some economists are forecasting that it could be almost 8% in April.

Why are costs rising?

From the weekly food shop, to filling up cars, to heating our homes, the cost of living is rising sharply around the world. Global inflation is at its highest since 2008. Some of the reasons why include:

  • Rising energy and petrol prices
    Oil prices slumped at the start of the pandemic, but demand has rocketed back since, and oil prices have hit a seven-year high. The price of gas has also shot up, leaving people around the world with eye-watering central heating bills. Home energy bills in the UK are set to rise by 54% in April when Ofgem, the energy regulator, raises the price cap.
  • Goods shortages
    During the pandemic, prices of everyday consumer goods increased. Consumers spent more on household goods and home improvements because they were stuck at home, couldn’t go out to eat or go on holiday. Manufacturers in places such as Asia have struggled to keep up with the demand. This has led to shortages of materials such as plastic, concrete and steel, driving up prices. Timber cost as much as 80% more than usual in 2021 in the UK.
  • Shipping costs
    Global shipping companies have been overwhelmed by surging demand after the pandemic and have responded by raising shipping charges. Retailers are now having to pay a lot more to get goods into stores. These prices are now being passed on to consumers. Air freight fees have also increased, having been made worse by a lorry driver shortage in Europe.
  • Rising wages
    During the pandemic many people changed jobs, or even quit the workforce – a problem exacerbated in the UK by Brexit as many European workers returned to their home countries. Firms are now having problems recruiting staff such as drivers, food processors and restaurant waiters. This has resulted in companies putting up wages to attract and retain staff. Those extra costs to employers are again being passed on to consumers.
  • Extreme weather impact
    Extreme weather in many parts of the world has contributed to inflation. Global oil supplies took a hit from hurricanes which damaged US oil infrastructure. Fierce storms in Texas also worsened the problems in meeting the demand for microchips. The cost of coffee has also jumped after Brazil had a poor harvest following its most severe drought in almost a century.
  • Trade barriers
    More costly imports are also contributing to higher prices. New post-Brexit trading rules are estimated to have reduced imports from the EU to the UK by about a quarter in the first half of 2021. In the USA, import tariffs on Chinese goods have almost entirely been passed on to US customers in the form of higher prices. Chinese telecoms giant Huawei said last year that sanctions imposed on the company by the USA in 2019 were affecting US suppliers and global customers.
  • The end of pandemic support
    Governments are ending the support given to businesses during the pandemic. Public spending and borrowing increased across the world leading to tax rises. This has contributed to rises in the cost-of-living, while most people’s wages have lagged behind.

Main concerns for the UK inflation

With rapidly rising prices, the economic decisions people will have to make are much harder. The main concerns for UK households include increases in energy costs, food prices, rent and interest rates on borrowing. All of these concerns come at a time when the government prepares to increase national insurance contributions for workers in April. There has been some pressure from MPs to scrap the tax rise so as to ease the pressure on living costs. It can be argued that there are fairer ways to increase taxes than through national insurance. However, the plan is relatively progressive, and scrapping the rise could be a badly targeted way of helping the poorest households with their energy bills.

Energy Bills
Electricity and gas bills for a typical household are expected to increase on average by £693 a year in April, which, as we have seen, is a 54% increase. Around 18 million households on standard tariffs will see an average increase from £1277 to £1971 per year. And around 4.5 million prepayment customers will see an average increase of £708 – from £1309 to £2017. Energy bills won’t rise immediately for customers on fixed rates, but many are likely to see a significant increase when their deal ends.

Bills are going up because the energy price cap is being raised. The energy price cap is an example of a maximum price being imposed on the market; it is the maximum price suppliers in England, Wales and Scotland can charge households for their energy. Energy firms can increase bills by 54% when the new cap is introduced in April. The price cap is currently reviewed every 6 months and it is expected that that prices will rise again in October.

Energy price rises are likely to hit Britain’s poorest households the hardest as they spend proportionately more of their income on energy, a problem exacerbated by many living in poorly insulated homes. More people are thus expected to find themselves facing fuel poverty. This means that they spend a disproportionate amount of their income on energy and cannot afford to heat their homes adequately. According to the Resolution Foundation, the poorest will see their energy spend rise from 8.5% to 12% of their total household budget, three times the percentage for the richest.

The way fuel poverty is measured varies around the UK. In Scotland, a household is in fuel poverty if more than 10% of its income is spent on fuel and its remaining income isn’t enough to maintain an adequate standard of living. It is expected that the number of homes facing ‘fuel stress’ across the UK will treble to 6.3 million after April. It will, however, have the greatest impact on pensioners, people in local authority housing and low-income single-adult households who on average could be forced to spend over 50% of their income on gas and electricity. The Resolution Foundation thinktank has warned that UK households are facing a ‘cost of living catastrophe’.

Food
Low-income households also spend a larger proportion than average on food and will therefore be relatively more affected by increases in food prices. Food and non-alcoholic drink prices were up by 4.2% in the year to December 2021. The Monetary Policy Committee has stated that food price inflation is expected to increase in coming months, given higher input costs. It has been estimated by the thinktank, Food Foundation, that 4.7m Britons, equivalent to 8.8% of the population, are struggling to feed themselves and are regularly going a day without eating.

Supermarkets have also raised their concerns about future increases. Tesco’s chairman John Allan has predicted that the worst is yet to come, pointing to 5% as a likely figure for food price inflation by the spring. He cited high energy prices, both for Tesco and its suppliers, as a key factor behind the expected rise.

It has been observed that the Smart Price, Basics and Value range products offered by supermarkets as lower-cost alternatives are stealthily being extinguished from the shelves. This is leaving shoppers with no choice but to ‘level up’ to the supermarkets’ own better-quality branded goods – usually in smaller quantities at larger prices. The managing director of Iceland, Richard Walker, has stated that his stores are not losing customers to other competitors or to better offers, but to food banks and to hunger. This is a highly concerning statement given that 2.5m citizens were forced by an array of desperate circumstances to use food banks over the past year.

Rent
Private rents are also rising at their fastest rate in five years, intensifying the increase in the cost of living for millions of households. Data from the ONS reveal that the average cost of renting in the UK rose by 2% in 2021. This was the largest annual increase since 2017. The East Midlands had the biggest increase in average rental prices, with tenants paying 3.6% more than a year earlier. However, due to falling demand for city flats during lockdown, as people favoured working from home, London had the smallest increase at 0.1%. Nevertheless, as Covid restrictions are removed, renters, including office workers and students, are now returning back to cities. This is now pushing up rental prices with demand outpacing supply.

The property website Zoopla found newly advertised rental prices were rising much faster across the UK. It said the average rent jumped 8.3% in the final three months of 2021 to £969 a month. This increase in rental prices, combined with the general rise in prices will place additional pressure on the government to increase support for vulnerable families. The housing charity, Shelter, has reported an increase in people who are struggling to pay their rent and even pay their electricity. With Covid-era protections having ended, if people struggle to pay, they are faced with eviction or even homelessness. There are calls for the government to support such people by reversing welfare cuts.

Insurer, Legal & General, has announced an additional investment over the next 5 years of £2.5bn on its ‘build to rent’ schemes. The aim is to provide more than 7000 purpose-built rental homes in UK towns and cities. L&G claims that the additional homes are part of the solution to the rental problem, with rent increases being capped at 5% for five years. However, sceptics claim the company is simply trying to cash in on the booming market and there are calls for further government action. The Joseph Rowntree Foundation claim that renters will struggle as rents in some areas have risen as much as 8%. Despite this, housing benefit has been frozen for two years and therefore there are calls for government to urgently relink housing benefit to the real cost of renting.

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Questions

  1. What other measures of inflation are used beside CPI inflation? How do they differ?
  2. If all consumers are facing approximately the same price increases for any given good or service, why are poor people being disproportionately hit by rising prices?
  3. For what reasons might the rate of inflation (a) rise further; (b) begin to fall?
  4. Examine a developed country other than the UK and find out how inflation is affecting its population. Is its experience similar to that in the UK? Does it differ in any way?