Will the energy price cap freeze bring down inflation?

Britain breathed a collective sigh of relief on its energy bills as Prime Minister Liz Truss confirmed plans to freeze the 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 ‘will give people certainty on energy bills, curb inflation and boost growth’.

Dealing with soaring energy bills was Liz Truss’s main priority after she took office three days ago, with concerns millions of Britons will fall into fuel poverty this winter and that many more would struggle to pay their bills.

It has even been claimed that it could take four or five percentage points off inflation compared to where we would have been next winter without it, but is that the case and will the vast expense of the energy bills freeze come with a kicker of lower inflation and less need to raise interest rates? 

What will the price freeze mean for inflation?

Inflation was at a 40 year high of 10.1 per cent in July, according to the ONS, and is expected to edge up slightly higher when figures are released this week.

Forecasts saw inflation soaring even further based on Ofgem’s planned energy price cap rise to £3,549 from 1 October and then an expected jump past £5,000 in 2023. 

The Bank of England’s chief economist Huw Pill said it was plausible inflation could reach 22 per cent. 

Energy bills will still 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 this and the energy price cap guarantee will stem a lot of the pain due to come down the line on monthly bills?

It will also take the sting out for inflation figures, by dramatically limiting household energy costs compared to what they could have been. 

At 10.1 per cent, inflation is five times as high as the Bank of England’s 2 per cent target. Energy has been a principal driver of inflation since the reopening of the economy after Covid and has been exacerbated by the conflict in Ukraine.

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

Truss has said her plan will help to 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 that a price freeze could curb inflation. He was talking about plans to limit electricity prices by making it so that they are no longer based on expensive gas prices, but the energy price guarantee cap has a similar effect.

He said: ‘One of the things that does seem to be under consideration… is a change to the relationship between gas prices and retail gas prices in a direction that will lower headline inflation, relative to what were forecasting.’

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

It said: ‘Rather than rise from the 40-year high of 10.1 per cent in July to about 14.5 per cent in January, inflation may now peak at something like 11.5 per cent in November and then fall faster next year.’

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

Capital Economics predicts real household disposable income will fall by around 3 per cent in 2022 and 2 per cent in 2023, rather than the previously forecasted three per cent.

Janet Mui, head of market analysis at Brewin Dolphin adds: ‘If inflation is mechanically suppressed, it can also help to reduce bills that typically are linked to CPI or RPI.’

Will the energy price cap freeze limit base rate rises? 

Even with the freeze, inflation will continue to be a headache, bringing higher interest rates to slow the economy and making government debt more expensive to service.

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

But high energy costs are also delivering a similar chilling effect on the economy as rate rises would do, doing some of the Bank of England’s work for it. 

While the plan will reduce inflation in the near term, Paul Dales, chief UK economist at Capital Economics says ‘by supporting economic activity it will boost inflation further ahead… so looser fiscal policy will probably just lead to tighter monetary policy.

‘We’ve been expecting interest rates to rise to 3 per cent for a while, from 1.75 per cent now, but it’s becoming more and more likely that they rise further.’

Will energy help be enough for businesses? 

Households grab the headlines when it comes to energy bills but businesses have been suffering even worse, as they have no eenergy price cap.

Concern that spiralling bills could lead many to lay off staff, suspend activity, close their doors or even go bust has led to the Government stepping in to help them too.

They will benefit from a similar price limit but they only get six months confirmed help right now and details are limited as to how this will work and what will happen after that.

How does the price cap fix supply?

Even if the price cap does something to taper inflation the fundamental issue remains that energy supply is not currently meeting heightened demand and the market has been massively distorted by Russia’s invasion of Ukraine.

Yet, there is an underlying problem in the energy market too. Britain has a substantial amount of renewable energy, from wind and solar, and nuclear energy, which should generate electricity at a price far below the current market level.

However, wholesale electricity prices are set by the cost of the marginal source of generation, ie the cost of producing an extra unit of power, and Britain’s fallback option is gas generation. 

Overall, gas is responsible for only about 45 per cent of Britain’s electricity generation but dictates the price.

Gas heats about 80 per cent of UK homes, so the effect there is more obvious, but we only import about 4 per cent of our gas from Russia. Nonetheless, the gas price is set by international markets and so the disruption stemming from the war in Ukraine, international sanctions and Vladmir Putin’s weaponising of energy supplies hits British households.

Dales says: ‘If higher wholesale gas prices are here to stay, the system of domestic energy pricing in the UK needs to be reformed to better reflect the average marginal cost of electricity production from all sources. A price freeze would buy the government time to work out what this should look like.

‘Without reform of the domestic pricing system, there’s a real risk that wholesale prices will remain above a level consistent with any price freeze – meaning that retail prices then have to be increased when the freeze ends perhaps at the end of 2023.

‘A freeze in retail gas and electricity prices is an expensive sticking plaster, but not a long term solution.’

Truss’ plan to increase supply the Government includes an end to the ban on fracking and more than 100 new drilling licences for the North Sea.

Whether this will come to pass, given strong opposition, and in the time frame necessary remains to be seen.

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

There are also  concerns a price freeze will decentivise consumers from cutting consumption, which increases the risk of blackouts if energy supplies to Europe are throttled by Russia.

Paul Johnson, director of the Institute for Fiscal Studies, said: ‘There is a logic to people reducing energy use when there’s a shortage and prices are high. A top priority of the government ought to be encouraging people to use less energy.

‘If the price doesn’t go up to reflect the market price, in the end people won’t respond. This is going to be particularly true of higher-income households which use more energy.’

Despite this concern, as the price of energy is being capped per unit – at 34p/kWh for electricity and 10.3p/kWh for gas – it still remains the case that using less energy will pay off for households in the form of lower bills. 

What will the impact on markets and the pound be?

Capping energy bills helps households and businesses and should boost the economy, but it is hugely expensive – potentially £150billion if energy prices remain as forecast.

This left markets jittery on the announcement. Sterling continued its fall against the dollar and last weeked reach its lowest level in 37 years, however, it has rallied somewhat since, from under $1.15 to $1.17.

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

‘The doubt on fiscal sustainability from a Liz Truss government can be reflected to some extent by sterling falling to a 37-year low against the US dollar and UK gilt yields rising more than their US counterparts in recent months. 

‘This is problematic because weaker sterling means higher prices for imported products, while higher gilt yields mean it becomes ever more costly for the UK government to borrow.’

Richard Hunter, head of markets at interactive investor adds: ‘The additional headwinds of declining consumer confidence, persistent inflation and an almost inevitable recession add to an increasingly dour outlook for the UK in the short and perhaps even medium term.’