Tackling the root cause of energy bills could help us all on inflation

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The writer is chief economist at the Institute of Directors

In normal times, the Bank of England would go out of its way to avoid a recession, and not just because of the human cost. The “symmetric” nature of its inflation target means it is as concerned about undershooting as overshooting.

In a high inflation environment, however, such concerns are jettisoned. With shortages on the supply side — energy, superconductors, staff — it’s the simple laws of supply and demand that drive prices up. Given we can’t fix those any time soon, the only other option is to reduce demand. This is a tough love message: no wonder therefore that global equity markets have gone into a jitter as they try to process its implications.

Facing this situation, what the UK economy needs most of all is a moment when people believe inflation is peaking, and so will soon start to fall. Not only will that reassure central bankers that they don’t need to prioritise prices over steady growth, but it could also prove self-fulfilling if it calms expectations and so lessens the likelihood of factoring rising prices into every business decision.

As recently as January, the expectation was that inflation would peak in April when the household energy price cap was raised. Now, surveys of Institute of Directors members suggest it will be much further into the future. The irony is that the price cap, designed to protect consumers from volatile energy markets, is now delaying the moment at which people think we are through the worst.

For policymakers, however, this delay is also an opportunity, as it gives them time to decide on the nature of their response. So why not intervene on household bills in a way that directly reduces inflation? That would help persuade business and consumers that we are through the worst and therefore change behaviour. It’s a policy win-win: supporting vulnerable households at the same time as changing the inflation narrative.

This means the much-anticipated intervention by chancellor Rishi Sunak should address the root cause of the problem, namely the energy bill itself. This is what is in the basket of goods used to calculate consumer price inflation.

One option would be to reduce the rate of VAT on fuel but this is ill-targeted and potentially of limited impact since it can only be cut from the current rate of 5 per cent to zero. A better option would be to ramp up the support offered by the existing Warm Home Discount scheme, through which people on lower incomes apply to have their bills reduced. The government has recently decided to expand the scheme and make the payments automatic. This means much of the preparatory work has already been done.

In order to affect CPI, the subsidy to bills should be broad-based but could simultaneously be progressive. The scheme as currently designed has two groups based on differing needs; the most vulnerable could therefore receive more support in recognition that energy bills make up a higher proportion of their total household expenditure. It would also need to be directly funded from the Treasury — presumably from the proposed windfall tax — rather than being cross-subsidised from other bills.

By convention, Bank of England inflation forecasts do not take account of policy announcements that have not been officially made, even if they appear likely. However, if the chancellor announces his intention to reduce the actual bills that households will pay with the explicit aim of putting downward pressure on CPI, that would affect the official forecasts. In that way, by tackling the root cause, policy intervention can contribute directly to the sense that we are over the worst, which then in turn will start to improve the overall economic environment to the benefit of us all.



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