For those living in the United States there has recently been some good inflation news,
as falling energy prices reduced inflation for the month of July.
Europe is not nearly as lucky where all European countries except for France and Switzerland are
expected to have higher inflation in 2022 than the United States based on recent OECD estimates.
Germany’s central bank chief warned that the recent surge in energy prices was likely to drive
German inflation above 10 per cent this autumn and keep it elevated next year. Prices charged
by German industrial producers rose 37.2 per cent in the year to July, the highest increase ever.
Citigroup announced earlier this week that they expect the U.K. inflation rate to hit
18% next January, making the current U.S. inflation rate of 8.5% look quite mild.
One of the biggest reasons for the difference in inflation rates is energy costs, and in particular
the cost of natural gas. The front-month benchmark European natural gas contract
hit $291.9 per megawatt hour earlier this week. That would be around $490 a barrel on
an oil equivalent basis. Quite expensive. The cost of natural gas in the United States
has risen too, but to a much lower absolute price. That is because the U.S became a
major energy producer in recent decades while Europe reduced their production of fossil fuels
and relied on Russia as a major supplier of oil and gas. Those imported supplies have declined
since the Russian invasion of Ukraine. The UK energy regulator Ofgem is expected to
announce this Friday an increase in the energy price cap, to more than £3,500 for an average
household’s energy needs. That is an increase of 75 per cent on current levels. This means that
more than 10% of the average household income in the UK will be spent on energy. Continental
European gas prices are at present more than 14 times their average of the past decade.
The cost-of-living crisis is made worse by falling inflation adjusted wages. Real wages in the UK
fell at the fastest rate for at least 20 years in the second quarter of this year. This squeeze
occurred despite strong pay growth and a lively jobs market. Wages actually went up by 4.7% in
nominal terms over the period, but the rise in pay was dwarfed by the rocketing cost of living.
Certain commodities like milk which have seen no price rises in over a decade are now up 40% in
the last year in Europe, while being up only 15% over the same time period in the United States.
Why has the price of milk gone up so much? Well, two of the biggest inputs for dairy farmers
are cattle feed and fertilizer which are up 83 per cent and 179 per cent respectively over the
last year. The price of synthetic fertilizer is mostly driven by the cost of natural gas,
and of course the cost of cattle feed is driven by the cost of fertilizer and transportation.
Water scarcity has hit more than 60 percent of Europe from Italy to the United Kingdom.
An unusually dry winter followed by a hot and dry summer have caused record low river levels.
This shortage is affecting nearly all sectors from agriculture to the shipping industry.
The low river levels mean that cargo ships have had to reduce their loads leading to higher
transport costs and supply chain delays. UK house prices rose at an annual rate
of 11 per cent last month marking the 12th consecutive monthly rise. In the rest of
Europe house prices and rents have been rising too. Despite all of the talk of the shift to
hybrid work, Central London apartment rents are 6% higher than they were pre pandemic.
In the UK small and medium sized enterprises which together employ around three-fifths of
the UK workforce are feeling the squeeze from increasing wage bills, higher raw material costs,
the supply chain crunch and the fallout from Brexit. In the second quarter, almost all small
businesses in the hospitality, manufacturing, construction and retail sectors reported higher
input costs than in the same quarter last year. The UK Federation of Small Businesses
has predicted that this winter more than five percent of these businesses could go under.
In the past many of these businesses would have struggled to pass on the cost increases they are
seeing to their customers, but the media spotlight on Russia’s invasion of Ukraine has made customers
more understanding of the predicament these businesses find themselves in.
Cost increases are coming at Europeans from all angles. In the United States only
around 10% of outstanding home mortgages are floating rate mortgages. Americans typically
buy homes with 30-year fixed rate loans. Most European mortgages on the other hand
are floating rate loans with a fixed rate for just the first five years. The type of mortgages
available varies by country within Europe too, with adjustable-rate mortgages most common in
Austria, Greece, Italy, Portugal and Spain. Because of the historically low interest rate
environment that we have seen over the last twenty years, the total debt service burden
on euro area households has remained stable, despite continuously rising levels of household
indebtedness. This rise in debt though has made households significantly more exposed
to being squeezed as interest rates rise. Most UK borrowers have mortgages where the
interest rate is currently fixed for the next short while, but about 1.3 million of those
fixed rate loan periods will expire this year and another 1.8 million are expected
to expire next year, according to UK Finance. Rising interest rates will cost many borrowers
much more than rising energy bills will. In a sign that UK pensioners are feeling
increasingly vulnerable about their financial position, the data shows a jump in the number
of over-65s either going back to work or staying in employment. This rise is likely
to have been caused by a desire among those of retirement age to ease financial pressures.
Inflation in the UK is not just squeezing the nation's citizens.
It is also hitting the government hard. Britain pioneered the issuance of inflation-linked bonds,
in the 1980s with the idea that the government’s commitment to reducing inflation would directly
lower borrowing costs. Soaring inflation is now exacerbating the pain of excessive debt.
Inflation linked bonds make up almost a quarter of total UK central government debt which compares
to 8 per cent in the United States and around 5 per cent in Germany. UK government interest
payments in June more than doubled - with this increase being entirely down to the rise in
inflation linked bond payments which are tied to the surging retail price index.
So, inflation is a real problem in Europe right now, and while there are many factors playing
into it, at the core, is the cost of energy. Russia, while part of the problem is by no means
entirely to blame. In the 1960s and 1970s, Europe was producing roughly the same amount of natural
gas that it was using, but production began to decline as the North Sea gas fields depleted,
and the Netherlands began shutting down extraction – the Netherlands has the largest
deposits of natural gas in the EU. Over the last twenty years or so,
Europe has been reducing its dependence on fossil fuels, (particularly coal) in order
to reach its climate goals. Germany even passed a law to phase out nuclear power altogether,
a plan that they accelerated in the wake of the Fukushima disaster in Japan. Interestingly
Japan today announced a plan to restore nuclear power due to the ongoing global power crisis.
Germany shut down half of its nuclear power stations last December and the final three nuclear
power stations are scheduled to be decommissioned this coming December, many are obviously arguing
that these plants should be kept running due to the current energy situation. Belgium, Switzerland
and The UK have been reducing their nuclear power generation capacity in recent decades too.
For these reasons, European nations have become increasingly reliant on Russian natural gas
to fill the gap between the phase out of their existing energy supplies, and their transition to
zero emissions renewables and storage which they plan to eventually use as a full replacement.
The war in Ukraine has simply underscored the risk for Europe of overdependence on
one – frequently unfriendly - energy provider. Another problem in the European energy markets
is the way the EU’s energy pricing system works. It operates on a model where wholesale electricity
costs reflect the price of the last unit of energy bought via auctions held in member states.
Most of the time, natural gas is the fuel that is needed to make sure enough energy is supplied to
meet demand. So even in countries like France — where cheaper nuclear power provides around
70 percent of electricity — natural gas prices still drive the wholesale electricity price.
And as the gas price has soared, so has the price of electricity. Part of the reason European
energy markets are structured this way is that it means that all suppliers in the market, including
cheaper to generate wind or solar installations, get the price paid for the most expensive offer
accepted. This subsidizes the capital-intensive installation of these technologies.
In contrast to Europe, the U.S. has become a major energy producer in recent decades,
but due to a lack of transportation infrastructure, the US can’t ship sufficient
natural gas to Europe to meet the demand. For much of the last decade the world economy got
by on the shale oil boom and without US production more than doubling between 2010 and 2019,
the world would have struggled to power itself, as conventional crude
oil production — oil drilled without fracking or from tar sands — stagnated over that period.
World economic growth still does require fossil fuel production, and without more investment and
exploration, there is unlikely to be sufficient supply in the medium term to meet demand.
The demonization of the fossil fuel industry - one of the most important industries in the
world - has meant that traditional energy projects have been starved of investment for quite some
time. Politicians are surprised when oil companies return capital to investors rather than investing
in new production, but equally they tell these companies that they will be shut down in the near
future and replaced with other sources of energy. The recent lack of investment in reliable energy
production and infrastructure has materially impacted the supply side of the equation.
It is estimated that as much as a trillion dollars in investment has been postponed or
canceled over the last few years, with a large part of that related to the ESG
and green energy pushes. Things may be changing somewhat,
a new European law was approved this month by the European parliament designating natural gas
and nuclear energy as sustainable. This came after months of fierce debate.
Very little can be done to immediately accelerate any transition from fossil fuels.
Britain’s planned micro nuclear reactors – which are a good idea - will not be completed
for at least a decade. Running electricity grids on base loads of solar and wind power
will require technological breakthroughs on electricity storage, and will equally require huge
extraction of lithium Nickel Cobalt and copper, well beyond what is happening right now.
More offshore drilling, of the kind opened up in the Gulf of Mexico and Alaska by Biden’s
Inflation Reduction Act, will require either higher sustained energy prices,
or investors becoming willing to pour in capital with no regard for the prospect of profit,
as these projects are expensive and require decades of production to break even
and eventually provide a return to investors. Right now oil and gas companies are being told
that these projects will be shut down by regulations long before they reach breakeven.
In many parts of Europe planning rules have made it extremely
difficult – or prohibitively expensive - for homeowners to adequately insulate their
homes, Modern insulation would greatly increase energy efficiency. It has up until recently been
seen as more important to preserve the historical appearance of buildings than to install things
like double glazed windows for example. So far, EU energy policy has been unsuccessful
in its promise to provide clean, reliable and affordable energy.
It has given Europe some of the world's most expensive, but clean energy. Consumer protection,
supply security and price moderation have not been prominent objectives for the EU up until now.
There is growing pressure in the UK to exploit shale gas, and Germany is
considering reopening coal-fired power plants in order to keep its economy running.
Norway and the Netherlands have the potential to step up oil and gas exploration and production,
but this may not happen for political reasons. To be clear, I’m not advocating for abandoning all
environmental policies, but it can be argued that additional CO2 emissions from European sources
would simply replace Russian CO2 emissions, and that fossil fuel extraction within Europe would
likely adhere to higher environmental standards than are applied in places like Russia.
Right now, European governments are trying to alleviate the pressures on households and
small businesses of the cost-of-living crisis, this involves state funding to reduce rising
energy bills by subsidizing distributors, as in France, or transferring money to citizens to pay
those bills, as in the UK or big subsidies for public transport as we are seeing in Spain.
In a world of global trade, even if the U.S. does avoid a recession, sluggish European growth could
weigh on global markets well into 2023. If you enjoyed today’s video, you should
watch this one next. Have a great day and see you again soon, bye!