How soaring energy costs could hobble the covid-19 recovery
FUEL PRICES over the past month show the same vertiginous upward slope as a covid-19 case count during a particularly brutal wave. Coal and gas prices have touched all-time highs. Asian spot prices for gas have jumped by nearly 1,000% in the past year. The cost of oil has soared as shortages of other fuels have pushed up demand for crude.
Surging energy costs are in many respects an expression of the same phenomenon driving supply-chain backlogs all over the world. An unexpectedly strong rebound in demand has run headlong into stagnant supply. Disruptions, such as shortfalls in hydroelectric-power production caused by droughts, have exacerbated the shortages. So has the rush to boost low inventories in response to the energy crunch. But surging fuel prices are also more ominous than supply-chain woes. Past energy shocks have been associated not only with inflation, but deep recessions, too, as exemplified by the economic travails of the 1970s. What does the latest crunch hold in store?
The inflationary consequences of costly energy are already apparent. In the euro area, headline annual inflation jumped to 3.4% in September, thanks to a 17.4% leap in energy costs. Underlying “core” inflation (which excludes food and energy prices) rose by a more modest 1.9%. In America underlying inflation ran hotter in September, at 4%. But a 24.8% increase in energy costs pushed the headline rate up even higher, to 5.4%. These figures are likely to rise further in coming months, since rocketing fuel prices in October have not yet made their way into the statistics.
The contribution of energy to inflation will begin to fade once prices plateau—as they may in coming months, and even sooner if winter proves no colder than usual. Recent analysis by economists at Goldman Sachs, a bank, suggests that the effect of energy costs on America’s year-on-year inflation rate stood at 2.15 percentage points in September and will likely rise to 2.5 percentage points by the end of this year—taking the headline rate to 5.8%, holding other components constant—before eventually turning slightly negative by the end of 2022.
What about the damage to growth? The predominant factor, in the near term at least, is the effect on consumption and investment. Over short time horizons, households and firms cannot easily cut energy use in response to rising costs, leaving less to spend on other goods and services. This effect, according to work by Paul Edelstein of State Street, a bank, and Lutz Kilian of the Federal Reserve Bank of Dallas, is concentrated in the consumption of durable goods; a rise of 10% in the price of energy is associated with a 4.7% decline in spending on durables (and a particularly large drop in purchases of vehicles).
Yet the researchers also note that consumption tends to fall by more in response to rising fuel costs than you might expect given the share of energy in budgets. That seems to be because energy shocks tend to depress sentiment. James Hamilton of the University of California, San Diego, studies historical oil shocks and finds that a 20% rise in the real price of energy is associated with a 15-point drop in an index of consumer confidence. (A gauge of American sentiment collected by the University of Michigan has fallen by nearly 17 points since April 2021.)
An energy-induced slump could be mitigated if consumers meet higher bills by drawing on savings. By the end of 2020, households across large rich economies had accumulated “excess”, or above-normal, savings equivalent to more than 6% of GDP. Nonetheless, analysts at Goldman reckon that costly energy will reduce the growth rate of consumption in America by 0.4 percentage points this year, and by 0.5 points in 2022. Those inclined to see the petrol tank as half full may note that slower consumption growth could help ease strains on supply chains, which have been stressed by especially strong demand for durable goods. Those who grumble that it is half empty may worry that power cuts in places like China could result in still more shortages.
Crucially, the toll of the shock will depend on how central banks respond. Fuel prices tend to feed through to households’ expectations of inflation. That will be unwelcome news for central bankers, who are already worrying about high inflation. Research by Mr Kilian and Xiaoqing Zhou, also of the Dallas Fed, suggests that energy prices mainly influence short-term expectations, rather than those further out. Those expectations could adjust just as quickly when energy prices fall. Some central banks, such as the Bank of England, may nevertheless worry that the energy shock worsens the risk that inflation expectations become unmoored from their targets. But the dilemma is that, if they overreact, they depress consumption further and induce deflationary pressure, just as energy prices return to earth.
A pity, the fuels
The longer prices stay high, the more their effects evolve. Households and firms will become better able to reduce their exposure to energy. Indeed, work by John Hassler, Per Krusell and Conny Olovsson of the Institute for International Economic Studies in Stockholm suggests that costly energy affects the nature of innovation. Firms direct inventive efforts so as to economise on scarce inputs. When energy is abundant, they focus on capital- or labour-saving innovation. When energy is scarce, by contrast, firms do more to improve the energy-efficiency of production, and innovation suffers—as it did in the 1970s.
The extent to which history repeats, however, also depends on what governments do. They could shield customers from higher energy prices, which would be politically popular but delay the moment of transition from dirty fuels. Or they could encourage more investment in renewable-power capacity, so that energy constraints bind less. Such bold action could end the threat posed by expensive coal, gas and oil, once and for all. ■
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This article appeared in the Finance & economics section of the print edition under the headline “Tanks for nothing”
