Will freezing the energy price cap lower inflation?

Britain breathed a collective sigh of relief over its energy bills when Prime Minister Liz Truss confirmed plans to freeze an average household’s gas and electricity bill at £2,500 for the next two years last week.

In a speech to the Commons, she promised the freeze would “give people certainty on energy bills, curb inflation and spur growth”.

Dealing with soaring energy bills was Liz Truss’ top priority after taking office three days ago, fearing millions of Britons could fall into fuel poverty this winter and many more struggling to pay their bills.

It has even been claimed that it could reduce inflation by four or five percentage points from where we would have been next winter without it, but is that the case and the vast expenditure associated with freezing utility bills? energy come with lower inflation and less need to raise interest rates?

Liz Truss has announced that energy bills will be frozen at £2,500 for two years in a bid to ease the cost of living crisis

What will the price freeze mean for inflation?

Inflation hit a 40-year high of 10.1% in July, according to the ONS, and is expected to rise slightly when figures are released this week.

Forecasts saw inflation soar even higher based on Ofgem’s projected rise in the price of energy to £3,549 from October 1 and then a projected jump beyond £5,000 in 2023 .

Bank of England chief economist Huw Pill said it was plausible that inflation could hit 22%.

Energy bills will continue to rise as the new average household cap is higher than the current energy price cap of £1,971 but there is also a £400 rebate on top of that and the guarantee Will capping energy prices eradicate much of the pain due down the line on monthly bills?

It will also dampen the inflation numbers, keeping household energy costs much lower than they could have been.

At 10.1%, inflation is five times higher than the Bank of England’s 2% target. Energy has been a major driver of inflation since the economy reopened after Covid and has been exacerbated by the conflict in Ukraine.

Last month, the Bank of England predicted that without intervention, inflation would peak above 13%, followed by a recession.

Truss said his plan would help reduce inflation by five percentage points, a conclusion also reached by economists.

Speaking to the Treasury Select Committee, the Bank of England’s chief economist, Huw Pill, said a price freeze could curb inflation. He was talking about plans to cap electricity prices by ensuring that they are no longer based on high gas prices, but the energy price guarantee cap has a similar effect.

He said: “One of the things that seems to be under consideration…is changing the relationship between gas prices and retail gas prices in a direction that will reduce headline inflation, relative to what which was planned.”

Capital Economics analysts predict that the policy will now reduce the inflation rate by around three percentage points.

He said: “Rather than falling from the 40-year high of 10.1% in July to around 14.5% in January, inflation could now peak at something like 11.5% in November and then fall further. soon next year.”

One of the benefits of lower inflation is that real incomes won’t fall as far as expected.

Capital Economics forecasts that real household disposable income will decline by around 3% in 2022 and 2% in 2023, instead of the 3% previously forecast.

Janet Mui, head of market analysis at Brewin Dolphin, adds: “If inflation is mechanically suppressed, it can also help reduce bills which are usually tied to CPI or RPI.”

Will freezing the energy price cap limit base rate increases?

Even with the freeze, inflation will continue to be a headache, driving higher interest rates to slow the economy and make public debt service more costly.

In theory, lower inflation means the Bank of England doesn’t need to raise interest rates as much to slow the economy and get the CPI back under control and start pushing it down towards target. by 2%.

But high energy costs also have a chilling effect on the economy similar to that of rate hikes, doing some of the Bank of England’s job for it.

While the plan will reduce inflation in the near term, Paul Dales, UK chief economist at Capital Economics, said that “by supporting economic activity it will boost inflation going forward… so looser fiscal policy is likely to only lead to tighter monetary policy.”

“We’ve been expecting interest rates to rise to 3% for some time, from 1.75% now, but it’s becoming increasingly likely that they will rise further.”

Will energy aid be enough for businesses?

Households make headlines when it comes to energy bills, but businesses suffer even more because they have no energy price cap.

The fear that spiraling bills could lead many people to lay off staff, suspend operations, close their doors or even go bankrupt has led the government to step in to help them too.

They’ll get a similar price cap, but they’re currently only getting confirmed six-month support and details are limited as to how it will work and what happens next.

How does the price cap fix supply?

Even if the price cap does something to reduce inflation, the fundamental problem remains that the energy supply does not currently meet increased demand and that the market has been massively distorted by the invasion of Ukraine by the Russia.

Yet there is also an underlying problem in the energy market. Britain has a substantial amount of renewable energy, wind, solar and nuclear, which should produce electricity at a price well below current market levels.

However, wholesale electricity prices are set by the cost of the marginal source of generation, i.e. the cost of generating an additional unit of power, and the UK fallback option is the gas production.

Overall, gas is only responsible for around 45% of Britain’s electricity generation, but dictates the price.

Gas heats around 80% of UK homes, so the effect is more obvious there, but we only import around 4% of our gas from Russia. Nevertheless, the price of gas is set by international markets and the disruption resulting from the war in Ukraine, international sanctions and Vladmir Putin’s militarization of energy supply is hitting British households.

Dales says: ‘While wholesale gas prices are here to stay, the UK home energy pricing system needs to be reformed to better reflect the average marginal cost of generating electricity from all sources. A price freeze would give the government time to figure out what that should look like.

“Without reform of the national pricing system, there is a real risk that wholesale prices will remain above a level consistent with any price freeze – meaning that retail prices will then have to be increased when the freeze takes hold. end, maybe end of 2023.

“A freeze on retail gas and electricity prices is an expensive band-aid, but not a long-term solution.”

Truss’ plan to increase the government’s supply includes an end to the fracking ban and more than 100 new drilling licenses for the North Sea.

It remains to be seen whether this will happen, given the strong opposition and in the necessary time frame.

In the immediate term, ministers are said to be drawing up plans for a public information campaign to encourage people to reduce their energy consumption this summer.

There are also fears that a price freeze could deter consumers from reducing consumption, increasing the risk of blackouts if Europe’s energy supply is throttled by Russia.

Paul Johnson, director of the Institute for Fiscal Studies, said: “There’s a logic to people cutting back on their energy use when there’s a shortage and prices are high.” One of the government’s main priorities should be to encourage people to use less energy.

“If the price doesn’t rise to reflect the market price, in the end people won’t respond. This is going to be especially true for higher-income households that use more energy.

Despite this concern, while the price of energy is capped per unit – at 34p/kWh for electricity and 10.3p/kWh for gas – the fact remains that lower energy consumption will pay off for households in the form of lower bills.

What will be the impact on the markets and the pound?

Capping energy bills helps households and businesses and is expected to boost the economy, but it is hugely expensive – potentially £150billion if energy prices stay on track.

This left markets jittery at the announcement. The pound continued to fall against the dollar and hit a 37-year low last week, but has since rebounded somewhat from below $1.15 to $1.17.

Mui says: “A bill freeze means it is literally an unlimited liability for the UK government as wholesale gas prices remain highly volatile. Financial markets are worried about fiscal sustainability, i.e. soaring government debt and budget deficit, and would demand a higher rate of return to offset the risk of lending to the UK government.

“Doubt over the fiscal sustainability of a Liz Truss government may be reflected to some extent in the pound sterling falling to a 37-year low against the US dollar and UK gilt yields rising more than their American counterparts in recent months.

“This is problematic because a weaker pound means higher prices for imported goods, while higher yields on gilts mean it is becoming increasingly expensive for the UK government to borrow.”

Richard Hunter, Head of Markets at Interactive Investor adds: “Additional headwinds of falling consumer confidence, lingering inflation and an almost inevitable recession add to an increasingly bleak outlook for the UK in the short and maybe even the medium term.”

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