The Correlation Between Energy Prices and Inflation

Exploring the Connection Between Energy Costs, Inflationary Pressures, and Economic Ripple Effects

When energy costs increase, inflation rates often follow suit, and vice versa. But how do inflation and energy costs impact each other, and how can this create a ripple effect across the economy?

Natural Gas

When industrial demand for natural gas increases, it can also impact residential consumers. In 2021, natural gas consumption reached its highest level since 1985, coinciding with a colder spring that strained residential heating needs. As businesses returned to pre-pandemic conditions, commercial demand also surged.

Liquefied Natural Gas Transport

Global demand increases can pressure the European liquefied natural gas (LNG) logistics industry, which transports LNG worldwide. In 2021, extreme freezing in Texas and droughts in South America, which reduced hydropower output, led to LNG supplies being diverted from residential consumers as heatwaves increased cooling requirements.

Crude Oil

When fossil fuel prices, like crude oil, increase, they can impact inflation. In the 1970s, inflation rose with the price of oil. While oil's influence on inflation remains, reliance on oil is lower today, reducing its potential impact compared to the 1970s.

Renewables

Renewable energy has slightly mitigated oil's influence on inflation as alternatives to fossil fuels are available. However, experts note that potentially expensive renewable energy could revive energy prices' impact on inflation.

The Ripple Effect: Cost of Living Crisis

Energy prices have been a significant topic in the UK recently, with rising costs contributing to the cost of living crisis. The UK government's Public Opinions and Social Trends bulletin revealed that of the 49% of adults reporting an increased cost of living, 81% cited rising gas or electricity bills. As a result, 44% of adults in Great Britain are using less fuel, such as gas or electricity, in their homes due to rising living costs.

Central Bank Policies in Responding to Energy-Induced Inflation

In recent years, central bank policies, particularly towards green energy, have garnered media attention for their potential impact on inflation.

Green Credit Policies, designed by central banks, support the low-carbon energy transition while aiming to reduce inflation. High initial costs for renewable energy projects, combined with infrastructure and production financing sensitivity to interest rate rises, drive these policies.

Historical Analysis of Energy Prices Contributing to Inflationary Periods

Political instability often underpins higher inflation rates. The Russia-Ukraine war in 2022 led to an energy crisis as Russia, one of the world's primary oil producers, increased prices as part of a geopolitical energy restriction process. During the first 10 months of Russia's occupation of Ukraine, energy prices reportedly increased by 33%.

In tandem, inflation also rose sharply in 2022, prompting central banks to tighten monetary policy. However, measuring core inflation after high energy price hikes doesn't always accurately represent continuing or underlying inflation.

Future Predictions for Energy Price Increases and Inflation

From 2021, energy prices started to increase, compounded by the geopolitical factors of the Russia-Ukraine war and businesses returning to pre-pandemic levels. Here are some future predictions for energy prices and their effect on inflation:

Prices May Increase Again

Energy prices in Europe reached an all-time high in 2022. While they have fallen, inflation remains high, and energy prices have not returned to previous lows. In the UK, prices are set to decrease later in 2024, but standing charges may increase by up to 10%.

Improving Energy Efficiency Will Contribute to Affordability

Improving the energy efficiency of residential and commercial buildings will be key to combating energy price hikes, as it will reduce overall energy consumption. If inflation rises, lower energy bills will have less overall impact.

As energy prices and inflation increase, interest rates on loans and financing for power plants, particularly for upfront cost-heavy renewable energy projects, are also likely to rise.

The interplay between energy prices and inflation is complex and influenced by various factors, including geopolitical events and market dynamics. As global energy demands evolve and political landscapes shift, understanding these connections is crucial for developing effective economic policies and strategies to mitigate the impact on consumers and businesses alike. Improving energy efficiency and diversifying energy sources will be vital steps in managing future energy price fluctuations and their ripple effects on the economy.