Energy, Energy, Energy

Energy is playing a critical role in the cost of living crisis that presently engulfs the world economy. Hardly a day goes by in the UK, for example, without a newspaper carrying headlines that concern spiraling fuel prices and how this is magnifying inflation tensions on the one hand and draining household purchasing power on the other. The latest raft of European inflation releases certainly attest to the outsized role that energy prices have played in driving consumer price inflation to recent highs. The consumer price of energy, for example, specifically accounted for between 40 and 45% of the respective y/y gains in the UK and Eurozone consumer price index in July (see figures 1 and 2 below). Nearly half of Europe's inflation problem, in other words, can be traced to energy.

The latest news, moreover, suggests such outsized contributions will, if anything, increase in the period immediately ahead. For natural gas prices (which Europe is heavily dependent on for its energy needs) have surged in recent days (see figure 3). That followed news late last week that Russia is to suspend supplies of natural gas to Europe via the Nord Stream 1 pipeline for three days at the end of the month for what it described as maintenance purposes.

Falling energy returns on investment

But as concerning as that sounds, it may still understate the degree to which the cost of energy is responsible, not just for Europe's current inflation difficulties, but for the world economy's broader – and longer-term - malaise. Columnist Matthew Syed neatly articulated this link in a recent piece for the UK's Sunday Times newspaper (See The future will be cold and dark). Citing Charles Hall, professor at the State University of New York, he argued that energy is a far bigger cog in the global economic machine than many observers possibly appreciate. It is, after all, used at every single step of every economic process. Although energy only accounts for around 5% or so of the output share of most major economies' GDP, without energy the world economy would arguably grind to a halt.

One of the key concepts in Hall's work is the "energy return on investment", or EROI. Partly because oil and other fossil fuels are now much less easy to find and extract, their EROI has been declining. But climate change may also now be contributing to falling EROIs because most renewable energy sources are not yet as efficient as fossil fuels. And some of them are not yet even close to breaking even (see figures 4 and 5 below).

Could this, as Hall further hypothesizes, be one of the key reasons why many major economies have seen much weaker productivity growth in recent years?

In truth more research needs to be undertaken in order to offer a definitive answer to that question. But as the charts below suggest, further research is certainly warranted.

Real consumer prices of energy have doubled over the last 50 years

Consider first the real inflation-adjusted price of energy index plotted in figure 6 below. This is measured with reference to the energy basket in the consumer price index calculated by the OECD for its member economies and deflated by the core (non-food, non-energy) component. Increases in this index therefore suggest the consumer price of energy is rising relative to other consumer prices (excluding food) and vice versa. The real price of energy rose by around 50% between 1970 and the early 1980s. It then lost all that ground from the mid-1980s until the late 1990s before climbing sharply again from 2000 to 2008. There followed a period when real prices on the whole (and barring some volatility) retreated again from 2010 to 2020. But since then real energy prices have shot up to stand at over 50 year highs. As things now stand in 2022, the real consumer price of energy has more than doubled relative to where it stood in 1970.

Let's next consider what impact the gyrations in the real energy price level have had on the world economy over this 50 year period.

Energy and recessions

To start with, those periods when real energy prices have risen sharply have typically been followed by a recessionary phase in the world economy. This can be seen in figure 7 below which shows the annual growth rate in real energy prices plotted against the shaded US recessionary phases (which usually coincide with global recessions). To be sure, higher real energy prices on many of these occasions could have been driven by excess aggregate demand that stoked, in turn, a broader inflation problem. Central banks often responded to this with force which was a key reason why a recessionary phase followed. Still, it's hard to refute that rising real energy prices played a contributing role in this, not least given the degree to which energy costs were rising so much faster than non-energy prices in advance of those recessions.

Energy and productivity

Next, periods where real energy prices have climbed or retreated over recent decades broadly coincide with (or have been followed by) declines or advances in trend productivity growth. Higher real energy prices in particular have tended to chime with weaker trend US manufacturing productivity growth and vice versa (see figure 8 below where trend productivity growth is measured with respect to its 5 year changes). This is perhaps unsurprising given the energy intensity of that sector.

These links between real energy prices and productivity growth tend to (tentatively) chime too with the international evidence in figure 9 below. This shows that economies that are relatively energy intensive – in the top left hand corner of the chart – have experienced a bigger slowdown in trend labour productivity growth in recent decades relative to those economies that are not as energy intensive in the bottom right hand corner.

Energy and real rates

Lastly, it is perhaps no surprise too that just as higher real energy prices have tended to chime with weaker productivity growth, so too have higher energy costs chimed with weaker trend real interest rates. We can see this in figure 10 below which shows the real price of energy plotted against the average natural rate of interest for several major economies. The latter are derived from an academic study from the US Fed (see Holston, Laubach and Williams) but ostensibly measure the real rate of interest in the major economies that is expected to prevail at full employment.

None of the above is to deny that other structural factors have been equally – and maybe even more - responsible for the trend decline in global real interest rates. In a widely telegraphed speech from the BoE Governor Andrew Bailey (Structural change and global R*) a couple of weeks ago he highlighted a recent working paper from the BoE underscoring the key role that ageing demographics, the shifting nature of companies' investment needs (from tangible to intangible capital sources) as well as poor productivity growth have had – and will continue to have – in keeping real rates low.

In conclusion, the energy sector is, to put it mildly, not only a source of extraordinary economic instability at present but may have been partly – or even largely - responsible too for the secular stagnation that has engulfed the world economy in recent years. Indeed its impact in inflating companies' costs and choking productivity growth should not be under-estimated. And while geopolitical instability and global demand patterns have played – and continue to play - a key role in driving energy prices, the shifting nature of the energy mix (toward renewables) and ebbing returns on energy investment are also likely to have played a big role.

As for the policy implications, while many central banks are still being heavily criticized for stoking inflationary pressures in the last few months, insofar as sky-high global energy prices remain a key source of those pressures, they may be fighting a rear-guard battle. Shifting nominal interest rates up a few basis points to "contain" real wage pressures (which are already slumping), or to slow economic growth (when the world economy is already skirting with recession) in the face of this energy-induced instability seems futile.

The supply side of the energy sector ought to the key focus for the world's policymakers at present. And that means more actively combatting current supply side shortages, harnessing investment in renewables and incentivizing investment and innovation in other cleaner energy sources too. Happily those policies featured heavily in the recent Inflation Reduction Act in the United States. Policymakers elsewhere should probably take note.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.