As the conflict in Ukraine escalates, Guy Foster, our Chief Strategist, discusses its impact on energy prices and consumers, and the potential monetary policy response.
The war in Ukraine is a human tragedy that affects those on the ground in ways that hopefully none of us will ever have to experience.
It would be absurd to compare the economic and financial challenges we, for example, will be facing in the UK with the hardships of those fearing for their lives in Ukraine, or even with those of the average Russian living under the pressure of sanctions.
However, the conflict is having financial and economic repercussions, particularly when it comes to energy prices and inflation more broadly.
Why has the conflict affected energy prices?
Russia is the second-biggest exporter of oil and the biggest exporter of natural gas. Recognising the importance that energy plays for the world at large, sanctions have carefully avoided oil and gas exports.
However, many of the companies required to deliver Russian energy assets to the market are refusing to handle Russian cargoes through fears that sanctions could broaden or because they do not want to be seen to support an aggressive foreign power. Furthermore, over the weekend, the US raised the prospect of going further and sanctioning Russian commodity exports to the US. As such, we are seeing sharp increases in the prices of commodities that Russia exports. In addition to oil and gas, Russia is also a big exporter of wheat, aluminium, copper and nickel.
What impact is this having on UK consumers?
The rise in oil prices currently puts petrol prices on course to hit around 180p per litre in March. In this instance, though, the added pressure from gas prices serves to compound the pain for European and UK households. Ofgem had already announced that the electricity price cap would rise by more than 50% in April. It will rise again sharply in October – possibly by more than 30%. Food prices were already rising
due to higher agricultural commodity prices, shipping, and labour costs. The sanctions will exacerbate those increases. Inflation, therefore, having been expected to peak early this year, could now remain at 7-8% for most of the year.
One silver lining is that consumers have built up record levels of cash after a couple of years of lower spending on leisure, hospitality and commuting during the pandemic. Many workers can use more discretion about when they need to attend the office, which may ease the cost burden a little.
Will we see a policy response?
The Bank of England’s monetary policy committee (MPC), which sets interest rates, has been tight-lipped on how it would treat a rise in commodity prices. In the past, it has seen it as a factor constraining the disposable income of consumers and has therefore tended to tolerate, or even risk invigorating, high inflation by keeping interest rates low to try to temper the squeeze on household incomes.
The MPC will be at least a little less willing to tolerate inflation this time around as the labour market is quite tight. Low unemployment and large numbers of vacancies tempt employees to switch employers in the search for higher salaries. The MPC can’t be too relaxed on this situation with inflation now likely to hit 8% and stay high for more of this year. So even if it expects inflation to surge further, it will likely raise interest rates a few more times this year.
The chancellor will be giving his spring statement in a fortnight. This is designed to be an opportunity to update Parliament on the economy rather than delivering a full budget as used to happen at this time of year. It offers an opportunity to adjust the tax and duty rates to lessen the impact of higher bills – currently more than half the cost of a litre of petrol or diesel is tax. However, this will need to be balanced against the chancellor’s desire to get the public finances back onto an even keel.
Is this happening everywhere?
The situation is similar but different around the world.
Continental Europe shares many of the same pressures, which increase with greater proximity to the fighting. The conflict has, however, shaken European governments into recognising the need to bolster their strategic independence by rebuilding their military, reorientating energy supply away from Russia and developing strategic industries in technology.
The US is typically much more sensitive to higher oil prices than its European peers. That’s because fuel duties in Europe soften the impact of movements in the oil price. With very little tax on gasoline, US prices tend to move closely with oil prices. In the first two months of this year, UK petrol prices rose 2% (but are rising sharply now) whereas gasoline prices were 10% higher1.
What else is driving prices higher?
Timing is everything and since last year the timing of momentous events has been extremely unfortunate. A series of freakish coincidences contributed to last year’s surge in inflation. A component of which was the undersupplied energy market. But the really unfortunate timing aspect now is that it is happening at a time when the American economy, in particular, shows signs of over-heating. With high jobs growth, and people leaving their jobs in search of higher wages at alternative employers, the strong labour market threatens to spark a spiral of companies raising prices to pay higher wages, only for employees to demand higher wages to pay the higher prices.
In many previous instances of market volatility we have seen falling interest rates reviving the market. In the current environment, however, the US Federal Reserve (central bank) will almost certainly keep raising interest rates to address domestic inflation, at least to some extent. That’s important because the Fed has been effective at suppressing volatility when it has cropped up in the past. Without its support, the market turmoil may last longer.
What is the longer-term outlook?
There are some silver linings. The fact that the world is still emerging from the pandemic gives a cushion of growth to soften the impact of higher consumer prices. Jobs growth in the US still seems set to provide a strong contribution to growth over the coming year. Finally, the increasing focus on supply chains, security, defence, and decarbonisation will require a lot of investment activity that can offset the lull in consumer activity.
So, while consumers may be feeling some short-term pain from rising prices, and the stock market environment is less favourable than it has been in recent years, the longer-term economic outlook remains largely positive. Although this, of course, offers little consolation in light of the tragic events in Ukraine.