The Impact of Energy Prices on UK Interest Rates and Inflation

Energy Prices and the Impact on UK Inflation

One of the biggest influences on inflation is energy prices. Everything we buy in a shop, no matter what it is, has been transported to the shop from the manufacturer and transported from the shop by the consumer. Include the energy used to manufacture all products (including food production) and you can see why the energy prices are so important to the economy.

When the switching off of one of British Petroleum's Alaskan oil pipes (Aug 2006) caused oil prices to spike to $78 per barrel, it looked like we might have been heading for the $100+ per barrel we predicted early in 2006. The oil price dropped down to about $55 per barrel by mid 2007, when the BP issue was resolved, and the US refineries knocked off-line by the 2005 hurricane season, were up and running again. Since then we had an upward trend with the oil price reaching around $140 per barrel in the summer of 2008 before dropping back to a low of $35 per barrel. The price is now around $50 per barrel, as OPEC has cut production in the face of falling world wide demand, showing how volatile the oil price has been over the last year.

In Britain we also saw the opening of a new gas pipeline from Norway which helped ease energy prices locally, and of course we've had a couple of fairly mild winter recently meaning we used a little less 'winter' energy anyway. One thing seems reasonably certain, and that's that UK's oil and gas won't last forever, so we are increasingly reliant on energy imports from elsewhere in the world, until we get to grips with improving our own independent energy generating capacity.

Continuing political instability in the Middle East still continues to hinder energy price stability, and we have seen Russia attempting to reassert its might by turning off gas supplies to their near neighbours. In 2006 it was the Ukraine, in 2007 it was Belorussia, in 2008 the Ukraine was under threat, and again in 2009 the Ukraine has had its supplies cut off from Russia, affecting not only the Ukraine but neighbouring European countries. Unfortunately a large portion of Europe's Natural gas requirements come from Russia through these countries. Although the Russians say they would not wish to spoil what is currently their largest market (i.e Western Europe), they continue to demonstrate how they will make political points to get their own way with their ex-Soviet satellites, and so even this energy supply is not guaranteed. The Russians also want to remind the West that they are still major players on the worlds political scene and they will no doubt use whatever means available to them to continue to make this point. The flexing of Russian military might in Georgia in 2008 also indicates that Russia sees itself as a major power in the world and that it perhaps doesn't feel the West is in a position to intervene in any expansion plans it may be considering.

China's energy demand has also been rising fast and those regimes based on an energy economy who have oil and gas but who do not particularly wish to sell to the West will have a ready market in the Far East. The current slow down in world trade may temporarily halt the growth of energy usage in China (less exports to the West means less goods to be manufactured and so less energy usage) but recessions (even depressions) don't last forever, so eventually Chinas energy usage will begin to grow again.

It seems that our energy problems are not going to be easily resolved in the medium term and so inflation will eventually creep up again. Even the UK Governments 2006 report on energy generation in the UK has finally recognised that no amount of new wind farms will be enough to take over the generation capacity of our gas and oil fired power station let alone the remaining nuclear stations. Even the Germans who have the most experience with wind farms over the last 25 years concede that it isn't economically viable to continue building wind farms to try replace oil and coal fired power stations. The nuclear option is back on the agenda as a generation method which doesn't produce CO2 and has a realistic chance of making a large contribution to generation capacity (but only in about ten years time and only if the decision to invest and build is made now).

The Impact of Energy Prices on UK Interest Rates

So will interest rates continue go up from here? We have a complex interplay of inflation coming from different areas. Apparently if you take the effects of the oil and agriculture inflation out of the picture, then inflation for other goods and services is still falling. However we all need to eat and power our homes so while the cost of buying a new fridge might still be falling, the cost of shipping it to your home and running it will still rise, as will the cost of the things you put in it.

The Bank of England (BoE) are treading a fine line between dealing with the credit crunch, preventing a depression and controlling inflation, simply because these problems require different interest rate policies to reduce their effects. As gloomy as all this sounds, BoE interest rates would have to go up by another 5% to get back to the long term average of 6%. However, BoE interest rates are unlikely to go much lower than the current 1% and in two to three years could stand higher. Even so it will probably still be less than the historic average.

So is this a good time to be buying property? Well, if you need a home to live in, and you are prepared to live there for at least 10 years then you would probably not lose out in that time frame. You would be gaining the utility value of the property which is after all what building a house is for. If you are a property investor who wishes to build up a long term portfolio of property and again are prepared to hold (and fund where necessary) for  more than 10 years, then the next year or so may be a reasonable time to begin to add to the portfolio, especially if you go bargain hunting at property auctions.

However if you are a short term investor looking to turn property round in a few months or a couple of years, then now may not be the time to invest, unless you are building from scratch (building firms may become more desperate for work and so offer keener pricing to build new property). Property prices may have further to fall before the prices and loan values which lender are willing to offer, come back into sensible affordability for first time buyers and first time movers.

Even with the current reduction in property prices, we are probably seeing a much needed correction in asset value. If the property market values drop by 20% from the peak in Q3 2007 than we go back to prices of just 5 years ago (Q3 2003 - based on Nationwide house price data adjusted for inflation). So if you've owned your property for more than 5 years and are in no immediate hurry to sell, and assuming you can maintain your mortgage payments, then you shouldn't lose much asset value based on the original purchase price. Of course, people who have been active in the property market within the last five years (especially 2006/07) will suffer from negative equity, but again if you are in no hurry to move, you can sit out the downturn. For those people who need to move or remortgage right now, having bought recently, they may have difficulty raising a new mortgage and so should speak to a mortgage adviser to see what options are available.

Will these trends continue? Well consider the following. We live on a relatively crowded island, and as my old granddad used to say, 'They don't make land anymore!'. The current Government is committed to building another 300,000 homes, just to catch up with current demand which is rising year on year due to demographic trends. All this at a time when the new build rate in 2007 was running at about 190,000 houses per annum, and the building rate in 2008 has shrunk because of the effects of the credit crunch.

And then we have global warming. Whatever the arguments about whether global warming is caused by man or nature, it seems clear that the Polar ice caps are melting, the weather is changing, and all that water has to go somewhere, leaving the definite possibility of rising sea levels and even less land to build on in Britain.

All these issues are going to limit the supply side of the equation. Hey ho, there's always a silver lining to any cloud (assuming you already own a property not built on a current or future flood plain)!

As always, when buying property, pick your location carefully and be prepared to own the property for a decade or more and you won't go far wrong. Of course, that's only our opinion and as the investment disclaimer goes, 'past performance is no guarantee of future returns', even if its all we've got to go on.