Yet another tax

This article was written by Richard Horswill. All views and opinions expressed are strictly his own.

Another oil and gas crisis driven by war! Sounds familiar. Ultimately this supply shock will drive up consumer prices particularly in non discretionary areas. Heating and eating are a given, however the impact on discretionary spending will be somewhat different. The dilemma seemingly being faced by Central Banks, particularly the BoE, is based upon their inflation expectations policy, which seemingly does not take into account supply side dynamics. It does seem somewhat bizarre that discussions within the ranks of the BoE suggest future interest rate increases based on higher energy costs feeding into the UK economy. This is something clearly worth commenting on.

Historically, oil shocks create recessions. One only needs looks back at the 1973 oil crisis which sent the UK economy into a severe economic downturn. Interestingly, during the period interest rates moved sharply higher from about 6% in 1972 to 13% by the end of 1973. Unsurprisingly, the oil crisis combined with higher interest rates contributed to a prolonged economic downturn. Is the BoE looking like repeating this by calling a “supply shock” inflation as they also did in 2022 with the Russia Ukraine conflict?

The UK economy has been blighted by a lack of growth since the 2008 great financial crisis. Notable subsequent global shocks including the European debt crisis, the pandemic and of course the already mentioned Russia Ukraine war have all added significant costs to a stretched UK treasury. In order to tackle these shocks, government has treated us to a supposed austerity, even though the debt to GDP ratio was rising nicely throughout the period as deficit spending was still necessary due to sluggish growth. Also, since the pandemic of 2020, we have been treated with both a type of austerity as UK infrastructure crumbles, but combined with massive tax increases and interest rate hikes provided for by an out of touch Central Bank. A double whammy to the great British public has occurred. Is it any surprise that the economy is on its knees? 

As of today, the current oil price which has initially seen prices rise at the pumps, will eventually trigger higher prices in the supermarket. As is keenly stated by media outlets and central bankers alike, inflation will need to be tamed potentially by higher interest rates. This however completely misses the actual reason for the increase in the cost of living. Higher oil and gas prices are effectively acting as another tax on the consumer, so why on earth would Central Banks increase interest rates? This would be counterproductive to the overall economy particularly when demand destruction would simultaneously be occurring on the discretionary side of the consumer economy. The consumer is just getting temporarily poorer due to a war. Once the war ends, which we hope will be soon, energy prices will come down in the same way they did from mid 2022 after the initial spike driven by the Russia Ukraine conflict. Thus the cure for high prices are high prices, not interest rate increases as prescribed by so many economists, politicians and journalists who are clearly not reading the tea leaves correctly. 

The global economy is reeling in the wake of the current war as the Straits of Hormuz are blocked. It has plunged global markets into a tailspin as the safe haven dollar is rising in value which also adds to the economic pain the UK suffers as a net importer. The current dollar short squeeze is a symptom of the war, but again, as a resolution is found to the conflict the dollar will likely weaken as global dollar flows normalise and oil prices ease. The sell off in all assets is a mechanical function of the current dollar shortage as these savings assets such as gold and government bonds are liquidated to ease international cash flows. Once we get back to the status quo, subject to no other crises erupting, the existing path will emerge which is one where gold will continue to outperform, due to a combination of banking risk driven by private credit issues and concerns over the U.S. debt levels and supposed de-dollarisation. However, the irony will be one where interest rates actually fall as the global growth dynamic remains anaemic and the safety of government debt will trump the concerns over the debt loads.  

The current war uncertainty will eventually become certainty and normalisation will be reflected in consumer spending habits. The “oil tax” will disperse leaving us all slightly poorer for the experience. However, as conflict ends, just maybe the actions will make the longer term certainty of supply easier should a new Iran emerge. This is yet to come to pass but we can all hope for the best. In the meantime, the longer the crisis goes on, the more likely a heavy recession will hit UK shores. Remember though, if it acts like a tax and smells like a tax, it typically is a tax. What it isn’t though is inflation!