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Food costs and interest rates rise as energy and fertilizer supplies are hit by the invasion

Economic growth
By Paul Hodges on 04-Sep-2022

It’s taken more than a decade for reality to dawn. But finally, policymakers have started to realise their computer models don’t work. Instead, they need to look out of the window at the real world as European Central Bank president, Christine Lagarde, noted last month:

“We can no longer rely exclusively on the (inflation) projections provided by our models – they have repeatedly had to be revised upwards over these past two years. There are things that the models don’t capture. Sometimes the unexpected happens. So we have to pay attention to traditional indicators while also monitoring empirical data and what we expect to happen in terms of geopolitics, energy price developments and demographics.” 

Unfortunately, we are all paying for their mistake, as the chart showing August prices for European power confirms:

  • European governments are scrambling to secure enough gas inventories ahead of winter as the energy crisis deepens and Russia makes further cuts to pipeline flows
  • German manufacturers are stopping production because of high energy prices caused by Russian cuts to gas supply
  • Opec is talking about cutting oil supply to raise prices, more Russian sanctions are coming, and the energy crisis is about to get much deeper in Europe
  • Meantime, interest rates are rising quite sharply as they play catch-up with current inflation

The UK is in a particularly bad position as the government has paid little attention to the problem. Instead, it has been focused on electing a new premier. But the rising cost of power is set to provide a major test for the new leader as the Policy Exchange chart shows:

  • British households face a £129bn ($150bn) increase in fuel costs – equal to 5% of GDP
  • Last October, electricity costs were £0.20/kWh and gas costs £0.035/kWh
  • Next month, they will rise to £0.51/kWh and £0.15/KWh
  • The average bill will rise by 80% to £3549/year, just as food and housing costs also surge

The UK also faces the problem that it lacks large volumes of gas storage, as the government has naively believed it will always be able to obtain supplies in the market. So recently, civil servants have been forced to make plans for emergency blackouts, should supplies run out in a cold winter.

The third chart from I.C.I.S. highlights the major risks now emerging in fertilizer and food markets. As industry body Fertilizers Europe has warned:

“The European fertilizer industry faces an unprecedented crisis with gas prices soaring over 1000% from levels a year ago.

“It is in full-fledged crisis because the European gas market is bust. The record high prices of natural gas, which represent 90% of industry’s variable production costs, makes it impossible for European producers to compete. As a result, over 70% of European production capacity has been curtailed.”

I have been warning here of the problems since April, and they are set to intensify:

“The proportion of household income spent on food is predicted to rise from 20% to 30% over the next year — a 50% increase. And the problem will get even worse in 2024.”

And as the World Bank and IMF have highlighted, there is a growing risk that famine will spread across parts of Africa and Asia.

It’s going to be a very difficult winter. Most of the world will be impacted as Europe bids up energy/food prices to keep its people warm and fed. And it would never have happened if policymakers had recognised the importance of geopolitics, energy markets and demographics.