Conflict in the Middle East: what are the economic implications?

The horrific scenes in the Middle East are first and foremost a human tragedy. Notwithstanding hopes for a rapid de-escalation of tensions, the complicated geopolitical dynamics in the region mean that there is a clear risk that the situation worsens in the days ahead. No one can predict the outcome of the current conflict, but we can assess the macroeconomic and market implications of renewed tensions in the Middle East.

The primary transmission mechanism of greater tensions in the region to the global economy would be through higher energy prices. The price of Brent crude climbed by about 4% on the Monday following Hamas’ attack on Israel, to around $88 per barrel, reflecting rising concern that disruption to oil supplies could conceivably push prices much higher in the future. Tensions in the region have in the past caused global oil prices to climb substantially: in the 1970s, oil prices quadrupled as the Middle East descended into war.

We had included the possibility of an energy supply shock as a potential – but unlikely – scenario for the global economy in our latest set of economic forecasts. This was predicated in large part on production cuts by the OPEC+ group of fossil fuel exporters, driving Brent up to $120 per barrel. Regional conflict could mean the supply shock takes a different form, but our scenario analysis remains a useful starting point for assessing the impact of recent developments. It pushes our forecasts in a stagflationary direction from our base case.  

Under this scenario, higher commodity prices lead to an increase in headline inflation, which in the US has fallen from a peak of 9% to 3-4% today. The risk of “second round effects” (the phenomenon of wages rising in response to higher prices) against a backdrop of tight global labour markets could prompt some central banks – notably the Federal Reserve – towards additional rate hikes. Lingering concerns about ingrained inflation would also delay the eventual pivot to rate cuts until later in 2024, meaning that monetary policy is more restrictive throughout next year. Tighter monetary policy and a squeeze on households from higher commodity prices would result in slower growth, creating a stagflationary outcome.

The fading effects of past increases in energy prices following Russia’s invasion of Ukraine in early 2022 have been a key driver of global disinflation over the past year. However, that trend had already begun to go into reverse even before recent events.

Tight labour markets, as underlined by the September payroll growth in the US and a fresh historic low in the eurozone’s unemployment rate in August, mean that any sustained increases in inflation could eventually feed through to wage settlements and cause inflation to be stickier for longer. With the Fed already opening the debate over a final rate hike in November, concerns about these second round effects could easily tip the balance towards another hike if oil prices climb further.

However, the immediate threat to broader inflation from higher energy prices should not be overstated. Indeed, our analysis shows that energy prices account for only 1.7% of core CPI, meaning that the direct impact of higher oil prices on underlying inflation would be minimal. It is the second round effects that will be of far greater concern to central banks – and consequently investors.