The war in Iran: rising energy prices and their impact

While Donald Trump has stated that the war will end “soon”, there is still great uncertainty about how the conflict will evolve. The longer the conflict lasts and the more it escalates, the larger its impact on global economic developments. The main consequences include higher energy prices, higher shipping prices, higher resin prices (affecting food prices globally) and aluminium prices, disrupted supply chains, and adverse effects on business and consumer confidence as a result of the increased uncertainty.

The rising energy prices will have the largest economic impact, and the energy markets remain highly volatile. Oil prices are currently 32% higher than when we prepared our scenario in February (see Figure 1), and TTF natural gas prices are even up more than 67% (see Figure 2). The futures markets show smaller increases, which suggests that the markets expect the situation to stabilise in the medium term.

However, further escalation could exert significant upward pressure on energy prices. The Middle East accounts for roughly 30% of global oil production and 17% of global natural gas production. Some 20% of global oil stocks and global LNG flows pass through the Strait of Hormuz. Iran itself supplies 4.5% of global oil production and 7% of global natural gas production.

The recent increase in oil and gas prices is likely to have a slightly negative impact on the growth of both the US and the European economy, given the temporary nature of the shock (according to the futures). It is also worth noting that the European and US economies have greatly reduced their dependence on oil and gas in the past few decades, which has improved their resilience to energy shocks. Having said that, the economic shock would become more severe if energy prices were to rise further and remain elevated for an extended period of time.

The current increase in energy prices is likely to have a larger impact on inflation, especially in the euro area, where natural gas prices have gone up considerably. The US still has prices under control with its largely domestic natural gas market. Inflation expectations for the next 12 months have indeed risen faster in the euro area than in the US (see Figure 3). Long-term inflation expectations remain well anchored for the time being.

The stagflationary nature of the present energy price shock presents a dilemma for banks. The immediate inflationary effect of the current shock will keep US inflation above the target level and will drive up euro area inflation to above the target level, but the downside risks to growth and employment will make many central banks reluctant to severely tighten their monetary policies in response to the shock. Nevertheless, the markets are currently expecting just one interest rate cut by the Fed this year (as opposed to two cuts before the war).

This shift occurred despite a favourable inflation report and a poor labour market report (revealing a loss of 92,000 jobs in February). The markets expect the ECB to announce two interest rate hikes this year, which, as mentioned above, is likely due to the greater inflationary impact in the euro area. It should be stressed that there is great uncertainty in this regard. If oil and gas prices were to rise even further and the shock were to become permanent, central banks would be able to pursue more restrictive policies.