The Government’s plan to cap household and corporate energy bills will be expensive and leaves the public finances exposed to the vagaries of wholesale gas prices. But the plan should significantly reduce the risk of the economy entering a recession. Moreover, by significantly lowering the prospective peak for inflation, the cap should help keep inflation expectations in check and encourage the Bank of England to take a milder approach to raising interest rates.
The EY ITEM Club now expects CPI inflation to peak below 11% in October, rather than the 15% peak which might have otherwise materialised. This may also yield some gains to the public finances from lower debt interest costs and a smaller uprating of social security benefits.
But the cap on energy bills will support disposable incomes and spending, implying that inflation may be higher in the medium term. So, the EY ITEM Club expects the Bank of England to continue raising interest rates, including a 50bps increase next week. But the chances of unexpectedly big rises have fallen.
While the proposed plan carries a potentially high fiscal cost, taking no action would have had its own consequences. Were households to have been exposed to energy bills next year in the £5,000 range implied by current wholesale gas prices, there may well have been a significant decline in discretionary spending and a recession.
Martin Beck, chief economic advisor to the EY ITEM Club, says: “The EY ITEM Club estimates that the recently announced support measures could cost around £100bn, although the Government will not present its own costing, or details on financing, until an emergency Budget later this month.
“Businesses will receive “equivalent” support to households, although this will last for only six months, versus two years for the latter. Following the six month period, ongoing support will be subject to a review, with focus set to be on “vulnerable industries”, such as hospitality. So as things stand, beyond next spring, companies will not enjoy the same certainty around energy costs as households. That said, if gas prices continue their recent decline, the proposed time-frame of support to firms may prove adequate.
“The proposed household cap is generous, so should reduce the risk of the economy falling into recession, as well as helping to ease the uncertainty which has surrounded the economy’s prospects. And by fixing the typical bill a little above already-elevated levels – allowing for the £400 rebate which all households will still receive later this year – it maintains incentives to cut energy use. That said, in absolute terms, most of the cap’s gains will go to better-off households, who use more energy.
“Following the announcement of the cap, the EY ITEM Club now expects CPI inflation to peak below 11% in October, rather than the 15% or so which might have otherwise materialised. A lower peak for inflation may dampen inflation expectations among the public, a development which would reassure the Monetary Policy Committee. But while the cap means the cost of energy to end-users will be lower than expected, the economic cost of that energy is still the same. And lower than predicted energy bills will support disposable incomes and spending, implying that inflation may be higher in the medium term.
“On balance, the EY ITEM Club doesn’t think the scale and nature of the Government's fiscal aid will stop the MPC from continuing to raise rates. But the chances of unexpectedly big rises – such as a 75bps rise in September’s meeting – have fallen.
“Undoubtedly, the new support package entails a significant fiscal cost and exposes the public sector balance sheet to a liability the size of which is unknowable at present – the cost may prove even bigger than expected if wholesale gas prices rise further, or if the winter proves unseasonably cold. But there would have been a significant fiscal cost to doing nothing. Were households to have been exposed to energy bills in the £5,000+ range, the consequence may well have been a decline in discretionary spending and a significant downturn in the economy, with all the fiscal costs of rising unemployment and falling tax revenues that would have implied. Moreover, by keeping inflation lower than otherwise, there will be some gains to the public finances in the form of lower interest payments on index-linked debt and a smaller uprating of social security benefits. And were gas prices to fall back unexpectedly, the cost of the cap will decline.
“Sterling has strengthened following the Government’s announcement which suggests that investors appreciate the merits of the package and the fiscal consequences of doing nothing. And with other countries joining the UK in announcing fiscal aid, or likely to do so soon, there should be safety in numbers, as far as the risk of any adverse market reaction is concerned.”