How soaring energy costs could hamper the recovery
FUEL PRICE over the past month show the same dizzying upward slope as a number of covid-19 cases during a particularly brutal wave. Coal and gas prices have reached historic highs. Asian gas spot prices have jumped nearly 1,000% in the past year. The cost of oil has skyrocketed as shortages of other fuels have driven up demand for crude.
Soaring energy costs are in many ways an expression of the same phenomenon that is causing supply chain backlogs around the world. A surprisingly strong rebound in demand rushed headlong into stagnant supply. Disruptions, such as shortages in hydropower generation caused by droughts, have exacerbated the shortages. The same is true of the rush to increase low stocks in response to the energy crisis. But soaring fuel prices are also more worrying than supply chain issues. Past energy shocks have been associated not only with inflation but also with deep recessions, as evidenced by the economic difficulties of the 1970s. What does the latest crunch have in store for you?
The inflationary consequences of expensive energy are already apparent. In the euro zone, headline annual inflation jumped to 3.4% in September, thanks to a 17.4% jump in energy costs. Core “core” inflation (which excludes food and energy prices) rose 1.9% more modestly. In America, core inflation accelerated in September to 4%. But a 24.8% increase in energy costs pushed the overall rate even higher, to 5.4%. These numbers are expected to rise further in the coming months, as the surge in fuel prices in October has yet to make its way into the statistics.
Energy’s contribution to inflation will start to fade once prices stabilize, as they might in the coming months, and even sooner if the winter does not turn out colder than usually. A recent analysis by economists at Goldman Sachs, a bank, suggests that the effect of energy costs on the annual inflation rate in the United States was 2.15 percentage points in September and will likely reach 2.5 percentage points by the end of this year — taking the overall rate to 5.8%, holding the other components constant, before finally turning slightly negative by the end of 2022.
What about damage to growth? The predominant factor, at least in the short term, is the effect on consumption and investment. In the short term, households and businesses cannot easily reduce their energy use in response to rising costs, leaving less to spend on other goods and services. This effect, according to the work of 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 10% increase in the price of energy is associated with a 4.7% drop in spending on durable goods (and a particularly large drop in vehicle purchases).
Yet the researchers also note that consumption tends to fall more in response to rising fuel costs than one would expect given the share of energy in budgets. This seems to be due to the fact that energy shocks tend to depress feeling. James Hamilton, University of California, San Diego, studies historic oil shocks, finds 20% rise in real energy prices associated with 15-point drop in consumer confidence index . (A gauge of American sentiment collected by the University of Michigan has fallen nearly 17 points since April 2021.)
An energy slump could be alleviated if consumers face higher bills by taking advantage of savings. By the end of 2020, households in large, wealthy economies had accumulated “excess” or greater than normal savings equivalent to more than 6% of GDP. Nonetheless, Goldman analysts estimate that expensive energy will reduce the growth rate of consumption in America by 0.4 percentage points this year and 0.5 points in 2022. Those who are inclined to see the reservoir of Half-full gasoline may note that slower growth in consumption could help ease tensions on supply chains, which have been strained by particularly strong demand for durable goods. Those who complain that it is half empty may fear that blackouts in places like China could lead to even more shortages.
Above all, the impact of the shock will depend on the reaction of central banks. Fuel prices tend to affect household inflation expectations. This will be bad news for central bankers, who are already worried about high inflation. Research by Mr. Kilian and Xiaoqing Zhou, also from the Dallas Fed, suggests that energy prices primarily influence short-term expectations, rather than longer-term ones. These expectations could adjust just as quickly when energy prices fall. Some central banks, such as the Bank of England, may nonetheless fear that the energy shock will increase the risk that inflation expectations will deviate from their targets. But the dilemma is that, if they overreact, they further depress consumption and induce deflationary pressure, just as energy prices come back to earth.
Too bad the fuels
The longer prices stay high, the more their effects change. Households and businesses will be better able to reduce their exposure to energy. Indeed, the work of John Hassler, Per Krusell and Conny Olovsson of the Institute for International Economic Studies in Stockholm suggests that expensive energy affects the nature of innovation. Companies are directing their inventiveness efforts to save on scarce inputs. When energy is plentiful, they focus on innovation that saves capital or labor. When energy is scarce, on the other hand, companies do more to improve the energy efficiency of production, and innovation suffers, as in the 1970s.
However, the extent to which history repeats itself also depends on what governments do. They could protect customers from rising energy prices, which would be politically popular but delay the timing of the transition from dirty fuels. Or they could encourage more investment in renewable energy capacity, so that energy constraints are less onerous. 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 and Economics section of the print edition under the title “Des chars pour rien”