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What do our scenarios tell us?
As the Middle East conflict grinds into its second month, the risk of an inflation surge and a destabilisation of financial markets is increasing. Even though the Trump Administration has announced its intention to end its military involvement within the next 2-3 weeks, it is unclear that this will lead to a swift reopening of the Strait of Hormuz.
We have modelled three potential scenarios for how the Iran conflict could impact global energy prices, including the implications for the economy, inflation and interest rates.
The Benign scenario assumes a short-lived conflict, with a temporary oil price spike that eases relatively quickly. This lifts inflation in the short term, but central banks can largely look through this due to its temporary nature.
The Malign scenario sees a larger increase in energy prices that takes longer to normalise. It is still a temporary shock, but places additional upward pressure on inflation that central banks cannot ignore, leading to upward pressure on interest rates that slows the economy.
The Malignant scenario assumes assumes a more prolonged conflict, with persistently higher energy prices leading to risks of a broader rise in inflation expectations. Sustained higher inflation requires more aggressive central bank responses, with interest rates rising to levels that could crack the economy and cause a bear market in equities.
While a benign scenario remains possible, our assessment is that the risk of a more malign outcome is rising. Given oil price rises to date, inflation will surge globally in the June quarter. In Australia for example, we estimate headline inflation will exceed 5% in the June quarter, even allowing for the halving in the excise tax on automotive fuel. In addition, we are seeing evidence of faster pass-through from higher fuel prices to other sectors, including transport, fertiliser, plastics and plumbing.
Central banks have been patient so far, with the US Federal Reserve, the Bank of England and the European Central Bank all resisting raising rates until there is greater clarity over the permanency of the oil price shock. Similarly, the Reserve Bank of Australia has limited its response by bringing forward a rate hike to March that it had already pencilled in for May.
Financial markets, however, are beginning to price a less optimistic outlook, with rate cuts being priced out of the US, and rate hikes being priced into Europe and the UK. In Australia, the market is anticipating between two to three additional 25bp rate hikes.
QIC’s view is that the RBA will need to raise rates to 4.35% at its next meeting in May, with the risk it will need to follow up with another move to 4.60% in June if energy-induced cost increases become more deeply embedded into the economy’s supply chain; particularly if it induces higher wage claims.
Despite the rising risks, if the Strait of Hormuz was to reopen by the end of June, our analysis indicates that the damage to the economy would be limited, and Australia and the global economy would avoid a recession. In contrast, if the Strait remains closed over the second half of the year, our analysis suggests that the oil price would spike higher and would take longer to return to pre-conflict levels after reopening. In this scenario, we would expect inflation in Australia to rise to 7% and for the RBA to take the cash rate to 5% or higher, making a recession likely.
Market responses have remained relatively contained despite significant volatility. US equities have avoided correction territory, having fallen by less than 10% since the conflict began. Perhaps more importantly, longer term market inflation expectations remain particularly well-behaved.
One month into the conflict, US long-term inflation expectations remain unchanged at 2.3%, suggesting markets expect only temporary impacts. Comparing current market reactions to those one month into the Russia-Ukraine war illustrates the difference between benign and malign/malignant scenarios. One month into the Russia-Ukraine war, market inflation expectations surged from 2.4% to 2.9%, forcing central banks to lift interest rates sharply and inducing a bear market in equities.
We are approaching a critical juncture in the Middle East conflict. As the conflict becomes more protracted, the greater is the risk that benign outcomes turn malign. A timely easing in geopolitical tensions that results in a reopening of the Strait of Hormuz would keep us in the benign camp and limit the economic fallout. But the absence of a resolution, or a resolution that leaves oil supplies compromised, pushes us closer to the malign or malignant scenarios, with substantial downside for the economy and financial markets.