Winter is the test for next year’s forecasts

Almost every economist’s global macro forecast for next year rests on one assumption: the energy price rises we’ve absorbed this year will fade, inflation will drift back to target, and central banks will be able to ease on the path already pencilled in. Winter is the first real test of that assumption.

Now that it’s October, we are paying extra attention to energy markets across Europe.

Supply is tight, but not yet broken

The UK and EU member states are required to hold significant emergency oil reserves—enough to cover 61 days of average domestic consumption or the equivalent of 90 days of net oil imports, whichever is higher. Those reserves, key to regional energy security, are pretty safe for now, thanks in part to daily US exports to Europe.

US energy dominance is not a new trend, despite what you may have heard in the past few weeks. Over the last decade America has become the world’s largest oil producer and, as a result, the largest diesel exporter (diesel being refined from crude oil). The challenge is that the war between Russia and Ukraine and the ongoing Iran conflict have combined to damage crude production and supply chains, and more recently the availability of diesel as refineries are attacked.

Diesel isn’t the only problem. The same conflicts have affected the flow and price of liquefied natural gas (LNG) heading to Europe through the Strait of Hormuz. EU gas storage is lower than at any point since 2022. In the UK, where natural gas heats 75% of homes, we have around 11 days of supply at the current rate of import. That number will fall if the conflicts continue and LNG consumption rises into winter, which it assuredly will.

Why diesel matters for inflation

These stressors have ripple effects that can’t be solved by everyone wearing heavier coats. Shipping and trucking get more expensive. One recent estimate suggests daily transport costs in the EU have risen by around $300 million since the start of the Iran war. Those costs are passed on to consumers everywhere. Amol Dhagalkar was complaining to me a few weeks ago that he filled his car with fuel in Pennsylvania and it was over $100. I’m jealous: the last time I filled mine in London, I paid over £150 ($200)!

But the pump is only the visible part. Diesel moves almost everything, so higher oil, diesel and LNG prices feed into food, goods and services, and into utility bills, just as the heating season begins. EU Energy Commissioner Dan Jørgensen has said nearly 50 million Europeans cannot afford to heat their homes adequately, up 20 million since 2019.

The assumption the outlook depends on

This is where it matters for markets. The inflation outlook for next year assumes the energy shock is temporary. Part of that is arithmetic: if prices stop rising, last year’s increases drop out of the annual comparison and headline inflation falls mechanically. But that only works if prices stabilise. A hard winter that pushes gas and diesel higher resets the base, pushes the fade further out, and gives second-round effects (food, freight, wages) more time to take hold.

That puts central banks in an awkward spot. The rate path currently priced for next year assumes inflation returns to target without much help. If energy costs stay high through the winter, they either hold rates higher for longer than expected, or they cut into inflation that hasn’t come down, which is a harder case to make.

There is a growth side too. When so many households are choosing between heating and spending, the shock hits consumption as well as prices. A cold, expensive winter is stagflationary, which is the one outcome current forecasts are not built around.

What could change this

Policy is a wild card. With US elections looming and domestic fuel costs soaring, the White House threatened a ban on diesel exports, something it has never done. That’s less likely now, but if it were to happen, it would raise European energy costs further. Any future releases of oil and diesel from strategic reserves, or a deal with Putin for Russian diesel, may offer short-term relief at the expense of long-term energy security. Action and inaction both have consequences. Either way, without a resolution in Iran, the fuel crisis will persist, and we will all foot the bill.

The so-what

We’ve been in a geopolitical recession for years now. The economist forecasts treat the energy shock as a passing episode that unwinds on schedule. If winter shows it’s closer to a condition than an episode, then both the inflation path and the rate outlook for next year will need to be reconsidered.

For now, for sure, winter is coming.