Tag: recession

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Will the housing market growth end with a crash? (updated 1/10/22)

In July this year, the UK saw the highest annual house price inflation rate since May 2003. The housing market is experiencing an excess demand for houses. There is a greater demand from buyers than there are homes for sale. This has led to a double-digit annual rise for the 10th consecutive month. Nationwide building society data show that UK house prices rose by 10% in the year to August 2022, with the typical property price rising by £50 000 in the past two years to £273 751.

The market has seen this continued growth in house prices despite the growing pressure on buyers’ budgets. It is even reported that estate agents are seeing a recent surge in activity. However, can the housing market continue to grow, or will we witness a crash?

House market activity

There are also signs that the housing market is now losing some momentum. According to the Nationwide, the average price of a home was £294 260 in August, 0.4% higher than the previous month. Although this marked another record high, the rise was less than earlier in the year. Halifax called the monthly rise ‘relatively modest’ compared with the rapid house price inflation that has been seen in recent times, where the average monthly increase in house prices has been 0.9%. The latest increase marked a return to growth for house prices, after they fell in July for the first time in more than a year.

However, the annual growth did slow in August, despite house prices still growing. The annual rate of house price growth dropped to 11.5% from 11.8% in July – the lowest level in three months. The Nationwide is predicting that an increase in energy costs and rising mortgage interest rates will add to the pressure on household budgets in the coming months. Energy prices are continually rising, and it is suggested that the least energy-efficient properties could typically see bills surge by £2700 a year, or £225 a month. This added squeeze on households’ disposable income, combined with the expectation that that inflation is set to remain in double digits into next year, is predicted to slow house price increases further or even cause them to fall.

Barratt Developments, the country’s biggest housebuilder, stated that the number of homes reserved each week until the end of August had fallen below the level of a year earlier, and was now lower than before the coronavirus pandemic. This has been partly driven by people anticipating further rises in interest rates and provides further evidence of a slowdown in the housing market.

Bank of England decisions on interest rates

In early August, the Bank of England announced its biggest increase in interest rates in 27 years, taking the UK base rate from 1.25% to 1.75%, a 13-year high. This rise in the base rate, which has a knock-on effect on other interest rates, was an attempt to control rising inflation as energy and food prices soared.

Then, on Thursday 22nd September, the Bank of England announced a further 0.5 percentage point rise in the base rate to 2.25%. This is now the highest level for 14 years, but this is unlikely to be the peak as it is expected that the Bank will continue raising rates into next year.

The government’s mini-Budget on 23 September involved a price cap on energy prices, estimated to cost around £150 billion, and various tax cuts. The package would be funded largely by borrowing. This is likely to drive interest rates up further. Indeed, in response to the package, the interest rate on new government bonds soared and price of existing bonds (which pay a fixed amount per annum) correspondingly fell, thereby increasing their yield. Yields rose above 4%; they were just 1.3% rate at the start of the year.

These further increases in interest rates will have a negative impact on the market as they feed through to mortgage rates, which have already increased noticeably recently. Indeed, following the mini-Budget and the rise in bond prices, around half the mortgage products on offer to new buyers or those re-mortgaging were withdrawn. Many households with mortgages will thus see their costs rise. Experts have warned that borrowers in the UK are especially exposed, with many people having mortgages tracking central bank rates or having short-term fixed deals set to expire. Those on fixed-rate deals will not be immediately affected, although their costs could jump when their deals come up for renewal.

The impact of a recession

Even though the housing market is slowing, it is nowhere near a crash. But, with the Bank of England predicting a recession, there is concern about the impact on the housing market. In August, the Bank had warned that Britain was likely to enter into a recession by December this year and predicted it to last 15 months. However, with the announcement of higher interest rates, the Bank now warns that the UK may already be in a recession. The central bank had previously expected the economy to grow between July and September, but it now believes it will have shrunk by 0.1%. This comes after the economy already shrank slightly between April and June.

A recession is defined as when an economy shrinks for two consecutive quarters. During a recession, house prices typically flatline or decrease but it all depends on how severe the recession is. Historically, when there is a deep and prolonged contraction in the economy with rising unemployment, house prices tend to fall.

Finance experts have predicted that the UK will suffer its longest downturn since the 2008 financial crisis. The global financial crisis saw the availability of mortgage finance contract, making it much harder for people to borrow, thereby reducing the demand for homes. This, together with rising unemployment, resulted in average house prices falling by 12%. It was not until 2010 that the housing market in London began to recover and not until 2013 in the wider UK market.

The BoE’s Monetary Policy Committee (MPC) have warned:

Real household post-tax income is projected to fall sharply in 2022 and 2023, while consumption growth turns negative.

This will be the first recession in the UK since the height of the Covid crisis 2020. However, then the housing market didn’t behave in the typical way and property prices continued rising. This was fuelled by people working from home, which encouraged both house movers and first-time buyers to seek houses with sufficient space. The housing market has been rampant ever since as people have taken advantage of low interest rates and also of the stamp duty holiday between July 2020 and September 2021 (see the blog, The red hot housing market).

This time, however, the predicted recession could finally put the brakes on growing house prices as people’s real incomes fall. With people faced with higher mortgage rates and the cost-of-living squeeze, the growth in demand for property is likely to slow rapidly: to 5% in the second half of this year and then lower still in 2023. This could eventually match the supply of property. Supply may also increase as a result of an increase in repossessions as people struggle to pay their monthly mortgage bills.

Cuts to stamp duty

In his mini-Budget on 23 September, the new Chancellor, Kwasi Kwarteng, announced that stamp duty on house purchases would be cut. The threshold at which buyers have to start paying the duty would rise from £125 000 to £250 000 and first-time buyers would not pay any duty on the first £425 000.

This cut in tax on house purchase will go some way to offsetting the effect of rising mortgage interest rates and is likely to reduce the slowdown in house price rises.

First time buyers

A recession could actually help some people climb onto the property ladder if it pushes property prices down. That would lead to smaller deposits being needed and lower total amounts having to be borrowed.

However, despite the prospect of falling house prices, it still remains tough for first-time buyers. The biggest risk for hopeful homebuyers in a recession is losing their job. At a time of increased uncertainty, some first-time buyers are likely to wait, hoping that homes will become cheaper. However, there have only been 31 months in the past 20 years when house prices have fallen, all of which occurred between 2008 and 2012. Myron Jobson, senior personal finance analyst at Interactive Investor said:

Fast-rising rents are not offering any relief and could keep some buyers in the hunt for a home for longer than they would like.

Also, prices are not yet actually falling, even though demand is slowing. Demand for homes is still outstripping the available housing inventory. This means that the market is still a difficult one for first-time buyers and those looking to climb up the property ladder.

At first sight, it may seem that cuts to stamp duty will help first-time buyers, especially as the duty is paid after a higher threshold than for other purchasers. However, the stamp duty cuts will stimulate demand, which, as we argued above, will reduce the slowdown in house price rises. Also, despite the threshold being higher for first-time buyers, by stimulating house price inflation, most if not all the gains in the duty cut could be offset and could risk pricing-out first-time buyers.

Conclusion

The economic outlook is uncertain. However, the rises in the energy price cap in October and beyond, and the general rise on the cost of living as prices rise faster than wages, are expected to increase pressure on household finances, which will limit the amount that prospective house buyers can afford to borrow. As a result, house price inflation is expected to fall across the majority of UK regions, as buyer demand eases. But just how much house price inflation will fall and whether it will turn negative (i.e. a fall in house prices) is hard to predict

Articles

Questions

  1. With the aid of a diagram, explain the current demand and supply in the housing market.
  2. How does an expectation of a rise in interest rates affect the demand for housing?
  3. Define the term recession. Why is the UK likely to enter recession (if it has not already done so)?
  4. Describe the characteristics of the business cycle during a recession.
  5. How do expectations of house price increases affect actual house price increases?
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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 confluence of calamities

World politicians, business leaders, charities and pressure groups are meeting in Davos at the 2022 World Economic Forum. Normally this event takes place in January each year, but it was postponed to this May because of Covid-19 and is the first face-to-face meeting since January 2020.

The meeting takes place amid a series of crises facing the world economy. The IMF’s Managing Director, Kristalina Georgieva, described the current situation as a ‘confluence of calamities’. Problems include:

  • Continuing hangovers from Covid have caused economic difficulties in many countries.
  • The bounceback from Covid has led to demand outpacing supply. The world is suffering from a range of supply-chain problems and shortages of key materials and components, such as computer chips.
  • The war in Ukraine has not only caused suffering in Ukraine itself, but has led to huge energy and food price increases as a result of sanctions and the difficulties in exporting wheat, sunflower oil and other foodstuffs.
  • Supply shocks have led to rising global inflation. This will feed into higher inflationary expectations, which will compound the problem if they result in higher prices and wages in response to higher costs.
  • Central banks have responded by raising interest rates. These dampen an already weakened global economy and could push the world into recession.
  • Global inequality is rising rapidly, both within countries and between countries, as Covid disruptions and higher food and energy prices hit the poor disproportionately. Poor people and countries also have a higher proportion of debt and are thus hit especially hard by higher interest rates.
  • Global warming is having increasing effects, with a growing incidence of floods, droughts and hurricanes. These lead to crop failures and the displacement of people.
  • Countries are increasingly resorting to trade restrictions as they seek to protect their own economies. These slow economic growth.

World leaders at Davos will be debating what can be done. One approach is to use fiscal policy. Indeed, Kristalina Georgieva said that her ‘main message is to recognise that the world must spend the billions necessary to contain Covid in order to gain trillions in output as a result’. But unless the increased expenditure is aimed specifically at tackling supply shortages and bottlenecks, it could simply add to rising inflation. Increasing aggregate demand in the context of supply shortages is not the solution.

In the long run, supply bottlenecks can be overcome with appropriate investment. This may require both greater globalisation and greater localisation, with investment in supply chains that use both local and international sources.

International sources can be widened with greater investment in manufacturing in some of the poorer developing countries. This would also help to tackle global inequality. Greater localisation for some inputs, especially heavier or more bulky ones, would help to reduce transport costs and the consumption of fuel.

With severe supply shocks, there are no simple solutions. With less supply, the world produces less and becomes poorer – at least temporarily until supply can increase again.

Articles

Discussion (video)

Report

Questions

  1. Draw an aggregate demand and supply diagram (AD/AS or DAD/DAS) to illustrate the effect of a supply shock on output and prices.
  2. Give some examples of supply-side policies that could help in the current situation.
  3. What are the arguments for and against countries using protectionist policies at the current time?
  4. What policies could countries adopt to alleviate rapid rises in the cost of living for people on low incomes? What problems do these policies pose?
  5. What are the arguments for and against imposing a windfall tax on energy companies and using the money to support poor people?
  6. If the world slips into recession, should central banks and governments use expansionary monetary and fiscal policies?
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Inflationary growth, stagflation or recession? Looking ahead

Inflation across the world has been rising. This has been caused by a rise in aggregate demand as the global economy has ‘bounced back’ from the pandemic, while supply-chain disruptions and tight labour markets constrain the ability of aggregate supply to respond to the rise in demand.

But what of the coming months? Will supply become more able to respond to demand as supply-chain issues ease, allowing further economic growth and an easing of inflationary pressures?

Or will higher inflation and higher taxes dampen real demand and cause growth, or even output, to fall? Are we about to enter an era of ‘stagflation’, where economies experience rising inflation and economic stagnation? And will stagnation be made worse by central banks which raise interest rates to dampen the inflation but, in the process, dampen spending.

Despite the worries of central banks, with inflation being higher than forecast a few months ago, forecasts (e.g. the OECD’s) are still for inflation to peak fairly soon and then to fall back to around 2 to 3 per cent by the beginning of 2023 – close to central bank target rates.

In the UK, annual CPI inflation reached 5.4% in December 2021. The UK Treasury’s January 2022 new monthly forecasts for the UK economy by 15 independent institutions give an average forecast of 4.0% for CPI inflation for 2022. In the USA, annual consumer price inflation reached 7 per cent in December 2021, but is forecast to fall to just over the target rate of 2% by the end of 2022.

If central banks respond to the current high inflation by raising interest rates more than very slightly and by stopping quantitative easing (QE), or even engaging in quantitative tightening (selling assets purchased under previous QE schemes), there is a severe risk of a sharp slowdown in economic activity. Household budgets are already being squeezed by the higher prices, especially energy and food prices. And people will face higher taxes as governments seek to reduce their debts, which soared with the Covid support packages during the pandemic.

The Fed has signalled that it will end its bond buying (QE) programme in March 2022 and may well raise interest rates at the same time. Quantitative tightening may then follow. But although GDP growth is still strong in the USA, Fed policy and stretched household budgets could well see spending slow and growth fall. Stagflation is less likely in the USA than in the UK and many other countries, but there is still the danger of over-reaction by the Fed given the predicted fall in inflation.

But there are reasons to be confident that stagflation can be avoided. Supply-chain bottlenecks are likely to ease and are already showing signs of doing so, with manufacturing production recovering and hold-ups at docks easing. The danger may increasingly become one of demand being excessively dampened rather than supply being constrained. Under these circumstances, inflation could rapidly fall, as is being forecast.

Nevertheless, as Covid restrictions ease, the hospitality and leisure sector is likely to see a resurgence in demand, despite stagnant or falling real disposable incomes, and here there are supply constraints in the form of staffing shortages. This could well lead to higher wages and prices in the sector, but probably not enough to prevent the fall in inflation.

Articles

Data

Questions

  1. Under what circumstances would stagflation be (a) more likely; (b) less likely?
  2. Find out the causes of stagflation in the early/mid-1970s.
  3. Argue the case for and against the Fed raising interest rates and ending its asset buying programme.
  4. Why are labour shortages likely to be higher in the UK than in many other countries?
  5. Research what is likely to happen to fuel prices over the next two years. How is this likely to impact on inflation and economic growth?
  6. Is the rise in prices likely to increase or decrease real wage inequality? Explain.
  7. Distinguish between cost-push and demand-pull inflation. Which of the two is more likely to result in stagflation?
  8. Why are inflationary expectations a major determinant of actual inflation? What influences inflationary expectations?
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The energy crisis

The global battle for fuel is expected to peak this winter. The combination of rising demand and a tightening of supply has sparked concerns of shortages in the market. Some people are worried about another ‘winter of discontent’. Gas prices have risen fivefold in Europe as a whole.

In the UK, consumers are likely to find that the natural gas needed to heat their homes this October will cost at least five times more than it did a year ago. This surge in wholesale gas prices has seen several UK energy suppliers stop trading as they are unable to make a profit. This is because of an energy price cap for some consumers and various fixed price deals they had signed with their customers.

There are thus fears of an energy crisis in the UK, especially if there is a cold winter. There are even warnings that during a cold snap, gas supply to various energy-intensive firms may be cut off. This comes at a time when some of these industries are struggling to make a profit.

Demand and supply

The current situation is a combination of long- and short-term factors. In spring 2020, the demand for gas actually decreased due to the pandemic. This resulted in low gas prices, reduced UK production and delayed maintenance work and investment along global supply chains. However, since early 2021, consumer demand for gas has soared. First, there was an increased demand due to the Artic weather conditions last winter. This was then followed by heatwaves in the USA and Europe over the summer, which saw an increase in the use of air conditioning units. With the increased demand combined with calm weather conditions, wind turbines couldn’t supply enough power to meet demand.

There has also been a longer-term impact on demand throughout the industry due to the move to cleaner energy. The transitioning to wind and solar has seen a medium-term increase in the demand for gas. There is also a long-term impact of the target for net zero economies in the UK and Europe. This has hindered investors’ willingness to invest in developing supplies of fossil fuels due the fact they could become obsolete over the next few decades.

Nations have also been unable to build up enough supplies for winter. This is partly due to Europe’s domestic gas stocks having declined by 30% per cent in the past decade. This heightened situation is leading to concerns that there will be black-outs or cut-offs in gas this winter.

Importation of gas

A concern for the UK is that it has scant storage facilities with no long-term storage. The UK currently has very modest amounts of storage – less than 6% of annual demand and some five times less than the average in the rest of Europe. It has been increasingly operating a ‘just-in-time model’, which is more affected by short-term price fluctuations in the wholesale gas market. With wind power generation remaining lower than average during summer 2021, more gas than usual has been used to generate electricity, leaving less gas to go into storage.

However, some argue that the problem is not just the UK’s physical supply of gas but demand for gas from elsewhere. Around half of the UK’s supply comes from its own production sites, while the rest is piped in from Europe or shipped in as liquefied natural gas (LNG) from the USA, Qatar and Russia. In 2019, the UK imported almost 20% of its gas through LNG shipments. However, Asian gas demand has grown rapidly, expanding by 50% over the past decade. This has meant that LNG has now become much harder to secure.

The issue is the price the UK has to pay to continue receiving these supplies. Some in the gas industry believe the price surge is only temporary, caused by economic disruptions, while many others say it highlights a structural weakness in a continent that has become too reliant on imported gas. It can be argued that the gas crisis has highlighted the lack of a coherent strategy to manage the gas industry as the UK transitions to a net zero economy. The lack of any industry investment in new capacity suggests that there is currently no business case for new long-term storage in the UK, especially as gas demand is expected to continue falling over the longer term.

Impact on consumers and industry

Gas prices for suppliers have increased fivefold over the past year. Therefore, many companies face a considerable rise in their bills. MSome may need to reduce or pause production – or even cease trading – which could cause job losses. Alternatively, they could pass on their increased costs to customers by charging them higher prices. Although energy-intensive industries are particularly exposed, every company that has to pay energy bills will be affected. Due to the growing concerns about the security of winter gas supplies those industries reliant on gas, such as the fertiliser industry, are restricting production, threatening various supply chains.

Most big domestic gas suppliers buy their gas months in advance, meaning they will most likely pass on the higher price rises they have experienced in the past few months. The increased demand and decreased supply has already meant meant that customers have faced higher prices for their energy. The UK has been badly hit because it’s one of Europe’s biggest users of natural gas – 85% of homes use gas central heating – and it also generates a third of the country’s electricity.

The rising bills are particularly an issue for those customers on a variable tariff. About 15 million households have seen their energy bills rise by 12% since the beginning of October due to the rise in the government’s energy price cap calculated by the regulator, Ofgem. A major concern is that this increase in bills comes at a time when the need to use more heating and lighting is approaching. It also coincides with other price rises hitting family budgets and the withdrawal of COVID support schemes.

Government intervention – maximum pricing

If the government feels that the equilibrium price in a particular market is too high, it can intervene in the market and set a maximum price. When the government intervenes in this way, it sets a price ceiling on certain basic goods or services and does not permit the price to go above that set limit. A maximum price is normally set for reasons of fairness and to benefit consumers on low incomes. Examples include energy price caps to order to control fuel bills, rent controls in order to improve affordability of housing, a cap on mobile roaming charges within the EU and price capping for regional monopoly water companies.

The energy price cap

Even without the prospect of a colder than normal winter, bills are still increasing. October’s increase in the fuel cap means that many annual household fuel bills will rise by £135 or more. The price cap sets the maximum price that suppliers in England, Wales and Scotland can charge domestic customers on a standard, or default tariff. The cap has come under the spotlight owing to the crisis among suppliers, which has seen eleven firms fold, with more expected.

The regulator Ofgem sets a price cap for domestic energy twice a year. The latest level came into place on 1 October. It is a cap on the price of energy that suppliers can charge. The price cap is based on a broad estimate of how much it costs a supplier to provide gas and electricity services to a customer. The calculation is mainly made up of wholesale energy costs, network costs such as maintaining pipes and wires, policy costs including Government social and environmental schemes, operating costs such as billing and metering services and VAT. Therefore, suppliers can only pass on legitimate costs of supplying energy and cannot charge more than the level of the price cap, although they can charge less. A household’s total bill is still determined by how much gas and electricity is used.

  • Those on standard tariffs, with typical household levels of energy use, will see an increase of £139.
  • People with prepayment meters, with average energy use, will see an annual increase of £153.
  • Households on fixed tariffs will be unaffected. However, those coming to the end of a contract are automatically moved to a default tariff set at the new level.

Ordinarily, customers are able to shop around for cheaper deals, but currently, the high wholesale prices of gas means that cheaper deals are not available.

Despite the cap limiting how much providers can raise prices, the current increase is the biggest (and to the highest amount) since the cap was introduced in January 2019. As providers are scarcely making a profit on gas, there are concerns that a further increase in wholesale prices will cause more suppliers to be forced out of business. Ofgem said that the cap is likely to go up again in April, the next time it is reviewed.

Conclusion

The record prices being paid by suppliers and deficits in gas supply across the world have stoked fears that the energy crisis will get worse. It comes at a time when households are already facing rising bills, while some energy-intensive industries have started to slow production. This has started to dent optimism around the post-pandemic economic recovery.

Historically, UK governments have trusted market mechanisms to deliver UK gas security. However, consumers are having to pay the cost of such an approach. The price cap has meant the UK’s gas bills have until now been typically lower than the EU average. However, the rise in prices comes on top of other economic problems such as labour shortages and increasing food prices, adding up to an unwelcome rise in the cost of living.

Video

Articles

UK government/Ofgem

Questions

  1. Using a supply and demand diagram, illustrate what has happened in the energy market over the past year.
  2. What are the advantages and disadvantages of government intervention in a free market?
  3. Explain why it is necessary for the regulator to intervene in the energy market.
  4. Using the concept of maximum pricing, illustrate how the price cap works.