Introduction

Higher energy prices have been a key factor leading to rising inflation outcomes around the world recently, especially in Europe and the US. Australia was more sheltered to higher energy prices because of reliance on domestically produced gas, more renewable energy coming into the mix and warmer weather. But, a combination of domestic and global factors has created our own issues in energy, pushing electricity and gas prices higher. We look at the implications of Australia’s energy “crisis” in this Econosights.

What is going on in energy?

Wholesale electricity prices have gone up 3 times in Australia since early April while wholesale gas prices are 3-4 times above normal levels (with divergences across the states and territories). The main factors driving the increases are:

• Less coal generation (55% of Australia’s electricity generation is from coal) due to coal plants being offline for longer than expected due to maintenance (and perhaps underinvestment in recent years in expectation of a move away from coal to renewables) which is increasing reliance on gas as a source of power (20% of electricity generation is from gas)
• Lower energy generation from renewables
• Low gas reserves (previous moratoriums around exploration of gas reserves have limited gas supplies)
• International factors (higher demand/ move away from Russian gas) lifting gas demand & prices.
• Colder weather in Australia increasing heating demand.

The big lift in wholesale prices will not be completely passed onto consumers yet because most consumers tend to be on a yearly fixed rate that typically get revised on 1 July (which is when the majority of consumers will see an increase in electricity and gas prices) and the wholesale cost is only about 30% of the total electricity price to retail consumers. The Australian Energy Market Operator has also imposed a wholesale price cap for gas which limits the pass-through of higher prices for consumers (although is big negative for smaller energy retailers).

Businesses are also impacted from higher energy prices, especially those in the industrial sector that use heavy machinery.

Implications for inflation

Energy is 3.5% of the consumer price basket (2.5% for electricity and 0.97% for gas). We expect that electricity prices will lift by 15% (on a yearly basis) which will add 0.5 percentage points to inflation and gas prices are expected to rise by 12% (on a yearly basis) which will add 0.1 percentage points to headline inflation. There will also be indirect impacts of higher energy costs passed on to consumers.

This means that we now expect headline inflation to reach a peak of 7% on an annual basis, revised up from 6.1% in the September quarter. Trimmed mean inflation (or the underlying inflation rate) is expected to lift to 5.5% on an annual basis (with the annual peak reached in the December quarter).

Implications for the Reserve Bank of Australia

The RBA usually looks through large swings in prices because temporary factors usually drive these ups and downs. The big spike in energy costs in the near-term will be temporary and electricity and gas price growth should slow into early 2023. Intererst rate hikes won’t do much to slow energy price rises. So, we don’t expect the lift in energy prices to change the future path for RBA monetary policy. The broad-based lift in inflation in Australia (with 56% of the consumer price basket recording a >3% increase in the March quarter) means that interest rates will keep rising over 2022 and probably into early 2023. We see the RBA lifting the cash rate to between 1.5%-2% by the end of this year and 2-2.5% by mid-2023. We give ranges for these estimates because there is uncertainty about how the economy will respond to higher interest rates given that it has been more than a decade since the last rate rise so many households (especially those with housing debt) are not used to interest rate rises. And, the impact on inflation from interest rate rises is also less clear because of all the recent supply-related inflation. Given the RBA’s new found hawkishness, rate hikes could end up being more front loaded.

Consumers and the cost of living

Consumers are being hit with many cost of living issues at once. Inflation is high for essential goods and services (see the chart below). Higher costs for essentials (rather than non-discretionary items) can often feel psychologically worse for consumers. Meat and seafood prices are up by 6.2% over the year to March, fruit and vegetables are 6.7% higher (related to supply disruptions from the flood and higher commodity prices used as in input into the supply chain), petrol prices were 35.1% higher over the year to March (from higher oil prices), and utilities prices are about to soar (as outlined in this note). And while volatile changes in prices for these items are not out of the ordinary, the issue is that all the price rises are happening at one time.

As inflation is rising, interest rates are also getting hiked. While interest rate rises should help to slow down the pace of inflation which will be positive for consumers, this will take some time and until then higher interest rates mean a higher cost of debt.

On our estimates, the share of housing interest payments to income (the best guide to debt servicability) has risen to 5.8% from 4.7% a year ago since the cash rate has been lifted by 75 basis points. Housing interest payments will rise further from here (see the chart above) and start to become a burden on household spending when housing interest payments relative to income go above 7% (based on the historical experience). This is likely to be reached when the cash rate is above 2%.

Wages growth is rising, but only slowly and not to the same pace as the lift in inflation. Annual wages growth was 2.4% as at March. This means that real wages (total wages growth less inflation) is running at a historic low rate of 2.7% (see chart below). While we expect wages growth to rise in response to the tight labour market, an increase in the minimum wage, higher enterprise bargaining agreement rates and the high inflation environment this won’t happen straight away and we see wages growth reaching 3.5% by early-mid 2023.

It is no surprise to see consumer sentiment has fallen significantly. The monthly Westpac/Melbourne Institute survey has fallen to its lowest level in 13 years with the “time to buy a major household item” sub-component plunging in recent months and the weekly Roy Morgan consumer confidence survey also at its weakest point in the history of the survey (not withstanding the early days of Covid when uncertainty was high).

Conclusion

The government has little direct influence over the short-term supply issues in the energy market, besides imposing “caps” on wholesale prices or limiting gas exports. Longer-term, the influence of the government is important in determining a smooth transition from coal-powered energy to a larger share of renewable energy.

High inflation is generally negative for inequality (lower income consumers spend more as a share of their income compared to higher income households. To assist consumers in the short-term, the government could look to do more rebates for energy plans (and are currently being used in some states). One-off “cost of living” payments to low and middle income households (like those done in the UK) would just add further fuel to inflation. Tax cuts will help consumers but major tax cuts aren’t planned to start until mid-2024. The other impact from the current situation is that there is likely to be an increase in demand for installations of solar panels and battery storage.