What does the European natural gas crisis mean for inflation?
We analyse what the natural gas price surge means for eurozone and UK inflation, the risks going into winter, and the possible response by policy makers.
The European wholesale price of natural gas has risen by 380% since the start of the year, raising concerns over the potential impact on inflation. Given households have little choice but to pay the increase in price, it could have a negative impact on demand for other goods and services, and raises the risk of indirect inflation, or even second-round wage inflation.
Households face a challenging winter
Households have faced tremendous uncertainty over the past two years due to the coronavirus pandemic. While the outlook for the economic recovery looks good, the spike in natural gas prices this winter adds another layer of uncertainty. This is unfortunate, as it has the potential to dent consumer confidence and temper the expected recovery in spending.
Many economists and indeed investors had failed to spot the divergence in gas and oil prices which started in May. The rise in gas prices gained momentum in July, before grabbing the headlines in September.
As chart 1 shows, the divergence between European gas prices and the price of Brent Crude oil is very unusual, as most natural gas is extracted as a bi-product of crude oil. Winter 2005 was the last time this happened, which was also the first year the price of European gas started to be traded independently, and not simply indexed to oil prices.
Why has the price of natural gas risen so high?
There are a number of both demand and supply factors that have contributed to the surge in prices, but the demand side seems to be dominating. According to the European Commission, a colder than usual winter over 2020 led to higher demand for home energy, which was then followed by a much warmer than normal summer, causing demand for electricity and air conditioning to spike.
A push for more environmentally friendly behaviour appears to have also contributed. There has been a gradual shift away from using heavy-polluting fuels such as oil and coal in the generation of electricity. And while renewables are expected to play a very important role in Europe’s energy transition, natural gas is filling the gap for now as the cleaner alternative, raising demand again.
The necessary shift to increased working from home caused by the pandemic is likely to have also contributed to higher energy use.
Finally and to a lesser extent, rising sales and usage of electric vehicles has been a factor, raising demand for electricity usage. According to a report by the European Commission, 350,000 new electric vehicles were registered in the first quarter of 2021, reaching 14% of market share sold. This is only expected to rise further as the sale of new combustion engine vehicles are phased out. By our estimate, the typical electric vehicle adds between a third and a half to a typical European households’ electricity usage per year.
Higher demand over the past year has led to reserves being greatly reduced heading into this winter, just as supply was also hit.
It is worth noting that natural gas is not a typical commodity. Once extracted, its physical properties make it difficult to store and transfer. It is still mostly piped, meaning that markets and pricing become regional rather than global. Though the process to liquify natural gas to aid with transportation (LNG) exists, it remains about 12.5% of global production, due to the complications and expense of the additional process. In short, Europe cannot simply buy more gas from elsewhere.
The biggest two sources of natural gas, Norway and Russia, have both seen output reduced this year. Norway has seen its production fall by 3% in the year to July (2021), with exports down 7.2%. The UK has also seen its production fall by 28% over the same period, with exports down by 59.2%. However, it is worth noting that supply from the UK has been diminishing for some time as the continental shelf matures, and it becomes more costly to extract from it.
Higher demand from Asia, in particular China, has meant that some of the supply may have been diverted there from Russia. China and many emerging markets are facing their own energy crisis due to a spike up in coal prices. For more, please see the note: What higher energy prices mean for emerging markets.
There are also accusations that Russia is limiting supply in order to gain political approval for the Nord Stream 2 pipeline. This is a newly constructed pipeline between Russia and Germany, built to bypass Ukraine, which is accused of syphoning supply as it passes through. Nord Stream 2 has many opponents, including the US, as the increased dependence on Russian supply is seen as risky from a geopolitical perspective.
Russian politicians have not shied away from using the situation to attempt to gain favour, and of course, Russian president Vladimir Putin has denied limiting gas supplies to Europe to drive up prices. For more analysis on supply constraints please see: Four charts that explain Europe’s power price surge.
Which countries are most impacted?
As mentioned earlier, this is very much a European energy crisis; however, countries will feel very different degrees of pain. Data taken for 2018 from the International Energy Agency (IEA) shows that of the largest economies, the Netherlands is most reliant on natural gas, with 43% as a share of its total energy use. Italy is next, with 41%, followed by the UK at 39% (Chart 2).
At the other end of the spectrum, Sweden only uses 2%, as it has invested heavily in renewables for many years (38%). France is also low with 15% gas share, as it relies far more on nuclear power (43%).
For the rest of this note, we will focus on the eurozone aggregate which, similar to Germany, has a 25% share coming from gas. We will then look at the UK separately due to the use of an energy price cap which complicates matters.
Impact on eurozone inflation
Our last forecast update had eurozone inflation using the harmonised index of consumer prices (HICP) at 2.1% in 2021, falling to 1.7% in 2022. Our analysis suggests that the rise in wholesale gas prices should add about 0.5-0.6 percentage points to inflation in 2022, meaning that inflation should now rise further next year, before falling back in 2023 (chart 3).
Inflation is currently rising due to a more general recovery in energy inflation which began last year, but also due to core inflation (headline excluding energy, food, alcohol and tobacco), which had been depressed by various tax cuts in 2020, and is now being distorted to the upside by the reversal of those cuts.
The main impact is likely to be seen in household’s gas inflation, which tends to follow the wholesale market in euros with about a six-month lag. Although some electricity is generated using natural gas, we found the relationship with wholesale gas to be very weak. That may be due to the alternative sources on offer, and the strong connectivity of the European transmission grid. European electricity price inflation is rising, but not by as much as suggested by gas prices.
We also use the forward markets to project the path of gas prices further out. A comparison of the latest implied path from forwards and the path from August (our last forecast update) and May can be see in chart 4 below. Forwards contracts imply that the spot (current) price will peak in January 2022 at about €3.20 - about 10% higher than where it sits at present.
For modelling inflation, the level is less important than the year-on-year change in gas prices. Chart 5 above shows that the annual inflation rate had recently peaked in July, but is now set to rise again, forming a new peak in October before falling back. Due to the lags mentioned earlier, this means that gas inflation is likely to continue to make a meaningful upwards contribution to headline HICP inflation until around September 2022, before falling back and making a slight negative contribution in 2023.
Impact on UK inflation
As mentioned earlier, the UK is more exposed than the average eurozone economy to the spike in gas prices. The analysis for the impact on inflation is complicated by the government-imposed energy price cap, which sets a maximum price energy companies are allowed to charge for variable rate tariffs. The price the cap is fixed at includes various administration prices and VAT, but key here is the wholesale price, taken as an average over a specific period.
For example, the latest increase in the cap occurred on 1 October 2021 and will be in place until the end of March 2022. The price rose for the default dual tariff (direct debit payments) from £1,138 per year to £1,277 – a 12.2% increase, and was based on the average wholesale price on the relevant forward contracts taken between February and July.
The energy price cap is therefore shielding many UK households (but not firms) from the full extent of the rise in energy prices, at least until the next adjustment in the cap, to be applied in April. At that point, based on the current forward curve, the cap would rise to £2,204 – a 73% increase (chart 6).
Based on forward contracts, gas prices stay elevated through most of 2022, before starting to come down in Spring 2023 and beyond.
It is worth noting that the variable tariffs that are subject to the cap are in “normal” times the most expensive energy tariffs available. Usually, energy providers offer more competitive fixed-term tariffs, locking in prices using the forwards markets. However, due to the sharp rise in wholesale prices, most households would struggle to find a fixed tariff that is less expensive that the current cap. But, looking ahead, when the forward contracts start to become cheaper than current spot rates, those cheaper fixed tariffs will return, and so the “variable” energy price cap will become less attractive for many households.
Like the eurozone forecast, the UK CPI forecast has headline inflation rising through the rest of this year, due to higher energy inflation but also the unwind of sector-specific VAT cuts, rising from 2.3% in 2021 to 2.7% in 2022, before falling back in 2023.
Our analysis modelling the impact of gas prices on the energy price cap, and what it means for household energy bills, suggests that UK CPI inflation could be as much as 0.8 percentage points higher in 2022, taking the average up for the year to 3.5%. However, as chart 7 below shows, the year-on-year path could be more difficult, peaking at around 4.5% y/y in April 2022 (the next energy price cap adjustment), before gradually falling back.
Risks and caveats
The above analysis is a first attempt to estimate the impact of the surge in gas prices. However, there are additional factors and risks that need to be considered for our next full forecast update in November.
To the upside, a very cold winter could easily lead to even higher prices than seen so far. In 2005, prices peaked in December, and we could see the same again.
We are likely to see indirect price effects arising from higher production costs. Higher producer prices are likely to eventually feed through to both higher goods and services inflation, though the extent will depend on how energy intensive the production process or activity is.
We could also see second round wage effects. Recruitment difficulties are being reported in a number of sectors, especially in the UK and Germany. Higher consumer inflation could be used as a bargaining point, which in turn raises costs, and eventual consumer prices.
As for downside risks to inflation, a mild winter could mean prices falling back faster than currently implied from forward markets.
Recent price falls following the suggestion from Russia that it could increase supplies (without specifics) suggests that there may still be significant amounts of speculative holdings of contracts in wholesale markets. More outflows could occur as these institutions would not really want to take delivery of actual gas supplies as contracts expire.
Price hedging by energy companies could mean that only some of the wholesale price spike makes it to households. See the point earlier about UK fixed vs. variable tariffs.
Moreover, as energy demand is price inelastic (demand is less sensitive to changes in prices), we expect households to prioritise paying for home energy supply and instead, reduce their consumption of other goods and services, putting downward pressure on the prices of those foregone goods and services.
Some companies will not be able to pass on the cost of higher energy prices with their goods or services, and may instead simply cease trading. This would contribute to higher unemployment, and reduced demand more generally in economies.
Lastly, governments are likely to intervene where they can to soften the impact on households. The Spanish and Italian governments have already stated that they will intervene. Press reports suggest that the UK government is considering temporarily cutting the 5% VAT charge on home energy to help.
Implications for monetary policy
Central banks across Europe will be keeping a close eye on developments, and preparing the narrative of higher inflation in the next year. Everything at this stage suggests that the energy price shock will be temporary by nature, but there is a risk that we could see additional ripples given there are significant supply constraints in most economies at present.
In our view, the energy price spike should be treated like a tax increase. Most of the energy is imported, and so extra money spent will be leaving the domestic economies. And because energy demand is price inelastic, households will likely see their purchasing power fall for other goods and services, ultimately proving to be deflationary for the rest of the economy.
Where labour markets are tight, there is a risk we could see additional wage inflation, which in turn could feed back on to demand. Indeed, However, given most economies have still not seen GDP return to being above pre-pandemic levels, let alone closed output gaps, is a period of temporarily higher inflation such a major risk?
Many companies are only just resuming their activities, with most being forced to borrow more to stay afloat during the pandemic. For manufacturers that face international competition (remember, this is a very European problem), raising prices will inevitably lead to a loss in competitiveness and market share. Therefore, they may decide to take a temporary hit to their margins instead.
So far, European Central Bank (ECB) governing council members have started to warn of higher inflation, but they have also suggested that they are ready to look through this form of transitory inflation. While inflation expectations are picking up in both household surveys and market derived measures, they remain at reasonable levels given the movement seen so far in prices. There are few signs of wages rising sharply either, and with a number of the big unions in Germany agreeing deals only back in March, the scope for large increases appears limited for now.
In contrast, there is a very clear split amongst Bank of England (BoE) members of the monetary policy committee. A number of hawkish members, led by governor Andrew Bailey, have signalled that policy would need to be tightened over the forecast horizon in order to keep inflation within the target range, and that the case for doing so has strengthened of late.
Money markets recently moved to price the first interest rate rise, assumed to be from 0.1% to 0.25%, by January 2022, and another rise to 0.50% by July 2022. Bailey had the chance to temper market expectations recently when speaking to the G30 group of central bankers, but instead stated that the BoE “will have to act” to curb inflationary pressures, but stopped short of providing a time horizon. Bailey appears to be concerned over the potential for inflation to last longer, and for supply constraints, exacerbated by Brexit, may make the UK more prone to higher inflation.
Other more dovish BoE members have recently argued the case against raising interest rates, and we suspect that the majority of the committee are willing to wait for more evidence of inflationary pressures elsewhere in the economy.
For now, we are going against the consensus by assuming that UK interest rates remain on hold through this year and next. The risks are clearly skewed to a hike sooner rather than later; however, we are concerned by a number of fragilities in the economy including premature fiscal tightening starting next year. For more on the vulnerabilities of the UK economy see: Can UK handle a rate rise as economy rebounds?
The spike European gas prices will predominantly feed through to higher home energy bills in coming months, which is likely to lead to higher inflation in 2022. We expect the rise in inflation to be temporary; however, households are likely to also face additional indirect inflation through higher production costs, feeding through to higher goods and services prices. Demand in the economy is likely to be lower, as the purchasing power of households is reduced.
Whether workers can negotiate higher wages will depend on how tight those labour markets are. And judging the degree of slack is difficult at present due to the use of government furlough schemes. But, unemployment rates remain elevated in most of Europe, with a significant number still relying on government support due to the pandemic.
The ECB is likely to look through this period of higher inflation, but the BoE appears more split on the matter. If markets are correct, then the UK should expect a rate hike imminently, with more to follow in 2022. This could prove to be the BoE’s “Trichet moment” – in reference to ECB president Jean-Claude Trichet who oversaw the first of two rate rises in 2011 after the global financial crisis – a move widely regarded as a policy error, which may have triggered the subsequent European Sovereign Debt Crisis.
We do not believe the BoE will follow through, as raising interest rates to hurt demand at a critical point in the post-pandemic recovery would be self-defeating, especially if supply in the economy is only temporarily constrained.
Central banks have been desperately trying to raise inflation since the global financial crisis, but not this type of inflation.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.