Why Are Energy Prices a Problem for Inflation?

nergy prices, or how much we pay for things like electricity and gas, can significantly impact our daily lives and the economy. After all, energy is the "fuel" that keeps the global economy running.

Like a car needs petrol, businesses and households need energy to function. So when energy prices go up, it can make everything more expensive.

Impact on the Economy

On a personal level, high energy prices can make it harder to pay bills and can eat into your disposable income. This means we have less money to spend on things we want or need, like food or buying a new pair of shoes. 

But this isn't just limited to energy bills. Almost every business you can think of will have energy costs baked into the price of the goods and services we buy. So, not only are your energy bills increasing but, likely, the cost of things you're buying will also increase in general.

That means inflation caused by rising energy prices can become quite broad throughout the economy, and it may be hard for consumers to find substitutes for the items they buy. 

If people have less money to spend, that could result in less consumer spending and a slowing economy. 

If coupled with a strong labour market, we may see wages increase as workers demand more pay, further complicating things if it leads to a wage-price spiral. 

Controlling Energy Prices

Central bank policy is good at targeting demand but it isn't so effective at targeting issues with supply. 

Suppose the price of energy is increasing due to a high level of demand. In that case, the Federal Reserve may look towards tightening policy to slow the economy, which should reduce energy demand. 

However, if the problems are supply-side, there's little the Federal Reserve can do to fix a specific issue. Instead, they are more likely to focus on other metrics and try to stop inflation from becoming broader and more persistent, such as through wages. 

Either way, if inflation increases, it's likely to result in tightening monetary policy, like raising interest rates. This is going to slow the economy and could even lead the economy into a recession. 

Not only are your bills and the things you're purchasing increasing, but borrowing costs are also increasing. That will make your mortgage payments and other debt more expensive.

Because of this, high energy prices can become a painful source of inflation that can be unavoidable for consumers and businesses, particularly if problems come from the supply side that isn't easily or quickly fixed.