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Middle East conflict spills over to domestic costs
Inflation is currently the number one challenge facing Australia’s economy. Just when we had been expecting to see the first signs of slowing inflation (the CPI data showed that headline inflation eased from 3.8% in January to 3.7% in February), we are instead seeing rising fuel prices pushing up costs of transport and other industries that are intensive in fuel usage.
The March CPI will capture the first full month of the oil shock triggered by the conflict in the Middle East. With global shipping through the Strait of Hormuz disrupted, prices of crude oil have risen sharply, and this has passed through to Australia’s retail petrol prices.
In February, prior to the start of the conflict in Iran, the unleaded petrol (ULP) price in Australia averaged around $1.70/litre. With prices of ULP currently around $2.50/litre, the average gain over March will be over 30%, which, on its own, will add a full percentage point (ppt) to CPI inflation in the month.
If ULP prices remain at $2.50/litre over April, they will contribute another 0.5ppt to the April CPI. Even if the conflict in the Middle East resolves relatively quickly and oil prices start to move lower over the September quarter (as suggested by oil futures contracts), annual headline inflation will peak at over 5% in the June quarter.
While the increased price of fuel is a substantial cost for consumers, the cost to industry is also significant. Road freight, mining and agricultural industries rely heavily on diesel fuel, and the rise in diesel prices has been even larger than ULP.
We estimate diesel prices rose by an average 40% over March and could rise by a further 20% over April. For the average road transport business, fuel makes up 20% of costs, so a 60% increase in the diesel price lifts costs by 12%, which cannot profitably be absorbed into margins.
To remain operational, businesses are forced to pass on some of the increased fuel cost leading to widespread announcements of fuel levies or surcharges from transport companies in recent weeks. The fact that companies are imposing surcharges, rather than raising prices, indicates that businesses are expecting the shock will be temporary.
The agriculture industry is also facing additional cost pressure through a rise in fertiliser prices. The Middle East accounts for just under half of global exports of urea, a nitrogen-rich fertiliser and input to the production of plastics, and prices have lifted by around 40% since the conflict began.
Australia is highly dependent on imported urea for fertiliser and has only limited domestic stockpiles. With April representing peak fertiliser demand as winter crops are sewn, farmers have little choice but to pay the higher prices.
The higher price for petrochemical-based materials is impacting the construction industry. Global resin suppliers have reported increases of around 30% in the prices of core construction plastics, including pipes, fittings and drainage products, which are used throughout residential, commercial and engineering projects.
At the same time, disruption to supply chains has led major global resin suppliers to invoke force majeure clauses because they can no longer guarantee prices, volumes or delivery schedules. The combination of higher costs and unreliable supply is adversely impacting the construction sector, increasing the likelihood the lift in inflationary pressures will show persistence as builders incorporate elevated input costs and growing uncertainty over material availability into contract pricing.
Higher fuel prices and the pass-through of cost pressures puts underlying inflation on track to reach almost 4.0%. In this environment, it is difficult to see the RBA holding the cash rate at 4.10%, and we expect a move to 4.35% in May.
However, the inflation outlook is very uncertain and is entirely hostage to the duration of the conflict in Iran. Currently, our central case is that the Strait of Hormuz will reopen sometime in the June quarter, and that oil prices and inflation will return to pre-conflict levels in 2027.
The longer the conflict drags on, the greater the risk that elevated fuel costs filter through the supply chain. As costs are passed on, the inflation impulse will intensify, requiring tighter monetary policy. Alternatively, a severe fuel supply shortage could force the RBA to maintain liquidity to the economy, requiring lower rates. We will see which scenario plays out over coming weeks.