Inflation is back on target, but the economy is far from secure
5 min read
Politics may have driven Rachel Reeves' speech on the new Government's fiscal inheritance, but our public finances remain precarious.
The aftermath of a pandemic-ridden economy beset by an energy crisis has left debt above 99 per cent of GDP. Inflation is back on target, and the economy is out of recession, but growth remains anaemic. Nothing other than luck shields the new Chancellor from the same battles as her predecessors.
The risk of a new inflation storm is far from over. With the Ukraine war still raging, conflict in the Middle East escalating, and countless other tension points bubbling away, making a new inflationary crisis a real possibility. The World Bank has warned oil prices could increase to above $100 per barrel if the conflict between Israel and its neighbours grows. The Office for Budget Responsibility estimates that a gas crisis each decade could cost the British economy 2-3 per cent of GDP per year and raise public debt by 13 per cent of GDP by 2050 unless we ditch the fuel.
Whatever the cause and its impact, Britain's economy needs to be ready. But it's not. As Onward's new research paper Target Practice warns, inflation may be back at the Bank of England's 2 per cent target, but Britain's economy remains perilously exposed to price shocks.
We are still heavily reliant on natural gas, which accounts for 40 per cent of the UK's energy consumption — the fourth highest of any nation in Europe. It contributes one-third of our electricity supply, compared to just 16 per cent in Germany and 9 per cent in France. More than eight in ten British homes require gas for heating. This dependency is why Britain suffered from the worst inflation of any G7 nation over the past three years.
And our vulnerability goes beyond energy. Britain is also highly reliant on certain food imports. Over eight in ten fresh fruits and nearly half of fresh vegetables sold in Britain are grown abroad. Supply disruptions, whether post-Brexit trade difficulties with Europe or extreme weather events impacting other nations' farmers, increase prices at home. But our food insecurity is also driven by the impact of climate change domestically. Look no further than this year's harvests to see it — yields have potentially dropped by a fifth because of the unusually heavy rainfall over winter and spring.
These are the fundamental drivers of inflation that monetary policy cannot solve. Other nations like the US are looking to supply-side measures to secure their economies. President Biden's Inflation Reduction Act is investing enormous sums into clean energy technology and industries, guarding against supply-chain vulnerabilities and international fossil fuel markets. But even before the Chancellor stood up in the House of Commons to declare the public finances were in a terrible state, it was clear Britain lacked the fiscal capacity to implement an equivalent programme with generous public subsidies.
The Labour Government cannot guarantee that prices will remain stable. A new crisis would blow any plans out of the water — the recent inflation surge cost the Treasury over £100 billion over just two years. Instead, the Government must develop a targeted supply-side programme through an Inflation Stability Strategy. It should set out targeted incentives, regulatory change, planning reform, supply chain security, and skills development in a comprehensive plan to reduce the UK's exposure to inflationary drivers and enhance its resilience to price shocks.
Firstly, the Government should implement a five-point plan to overcome the barriers to expanding “homegrown” renewables. This entails using Contracts for Difference (CfDs) more effectively to secure the required scale of renewable energy generation; continuing to optimise the planning system to accelerate consenting processes for renewables and transmission networks; updating financial regulations to lower renewables’ developments borrowing costs; mobilising public financial institutions and GB Energy to scale up new clean energy technologies; and committing to zonal electricity pricing, while shielding existing and upcoming CfD-backed renewables projects from impacts to support near term investment.
Secondly, demand for gas needs to be lowered and energy efficiency enhanced. To do this, the new Government must increase the attractiveness to households of investing in insulation and electrification. This involves introducing a new home energy efficiency loan scheme and removing legacy environmental levies to lower electricity bills. It also requires supporting farmers to reduce synthetic fertiliser application, shift greenhouses onto heat pumps, and help drivers switch to EVs by expanding access to and reducing the costs of charging.
Thirdly, as the UK transitions away from fossil fuels, emphasis must be placed on cultivating supply chains that are resilient to inflationary pressures. The new Government should work with AUKUS members and other strategic partners to secure critical minerals and support electricity network developers by enabling procurement coordination and demand aggregation. Food insecurity must also be addressed as the impacts of climate change increase. This can be achieved by expanding controlled environment farming to enhance the stability of domestic production and negotiating a veterinary deal with the EU to improve import supply.
Fourthly, skills gaps in the industries that will deliver a renewables-led, electrified economy need to be identified and addressed. This can partly be achieved by developing a skills passport for the energy industry to ease workers’ transition between sectors. But it also requires new training grants to overcome skills gaps in inflation-proofing industries, such as insulation and EV repair, and the establishment of new academies to build the future workforce.
And finally, the new Government should better embed price stability as a strategic priority across policy and regulation by extending the OBR’s forecast horizon to at least ten years and reviewing our heavy use of index-linked gilts.
Inflation has returned to where it should be. Now is the time to design and deliver an Inflation Stability Strategy to achieve long-term price stability and, with it, a thriving economy.
Ned Hammond is Onward's Head of Energy and Environment.
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