The Ceasefire: two steps forward, one step back?

Should policy makers Rob Peter to Pay Paul?

The week started with the usual Trump Administration playbook. First, take an overtly aggressive stance leading into a deadline. Second, deliver the TACO (Trump Always Chickens Out) and claim a resounding victory, despite gaining very little.

In fact, it seems that the Trump Administration largely agreed to following the key points of Iran’s (ambit) 10-point peace plan, which includes the cessation of hostilities in the region, including Lebanon, in return for a re-opening of the Strait of Hormuz. The agreed ceasefire is for two weeks to allow the US and Iran to try to come to a longer-term agreement, with talks to be held in Islamabad this weekend. 

Markets predictably rewarded the TACO with global equities rallying (the S&P 500 is now just 0.8% below its pre-conflict level) and oil prices falling by over 10% (although they still remain around 40% higher than their pre-conflict levels). The only problem is, Israel and Iran have failed to follow the script. Israel continues hostilities in Lebanon, Iran continues attacks on Gulf countries and the Strait of Hormuz remains effectively closed. What this last week has revealed (or at least reminded us of) is the deep nature of this conflict, which is rooted in the belief by the Israeli and Iranian governments that this war is about their very existence. The US now finds itself between these two irreconcilable belligerents, with the Trump Administration’s go-to TACO exit strategy in tatters.

Despite the short run euphoria of the markets, with the Strait of Hormuz no closer to being reopened than it was a week ago, and with oil prices remaining elevated, the risk is rising that the higher cost of energy will seep into the cost structure of the supply chain, raising not only the rate of headline inflation, but also underlying inflation and inflation expectations. In the parlance of our scenarios (see Is the Iran conflict shifting from the Benign to the Malign?), while markets are now pricing in a Benign scenario, we remain sceptical that we can declare that we are out of the woods just yet. 

With the risk of energy-driven inflation infiltrating the entire cost structure rising, the risk that central banks (including the RBA) will be forced to raise interest rates beyond current expectations is also rising. The approach of the RBA was recently articulated by the Bank’s Assistant Governor Dr Chris Kent, who commented at a KangaNews Debt Capital Market Summit that “A negative supply shock pushes up prices and leads to weaker economic activity, making us all poorer. Central banks cannot change that. But they can ensure that the initial rise in prices does not lead to a rise in longer term inflationary expectations and extended inflationary pressures.”

The key point being made by Dr Kent is that although the central bank cannot control the foreign price of oil, and hence the initial inflationary pressure experienced from such a shock at the petrol bowser, it can ensure that inflation does not spread. Its policy tool, higher interest rates, works by suppressing demand, which has the consequence of reducing inflationary pressures by lowering economic growth. 

In this environment, how should governments approach fiscal policy? The responses by Federal and State governments to the “cost-of-living shock” of 2022-2025 was to support households’ disposable incomes by providing electricity subsidies. Unfortunately, boosting the spending power of households, places upward pressure on prices, with the RBA forced to hike rates in response.

In other words, policies that support spending during a cost squeeze Rob Peter to Pay Paul, in that the government boost to household incomes is offset by the RBA’s increases in interest rates. Amongst economists, this is not a controversial view and in recent weeks, many economic commentators have been vocal in opposing the Rob Peter to Pay Paul approach. 

Rather than demand-side policies, fiscal policy should concentrate on the supply side. The government is already securing fuel supplies from abroad and releasing strategic fuel reserves to boost supply. In addition, they have reduced the heavy vehicle road user charge to zero for the next three months, lowering costs to road freight and agriculture. The government has also halved the fuel excise tax, which benefits both businesses and households.

Unfortunately, the additional demand for fuel by households puts further upward pressure on business costs. Currently, we need households to lower consumption of fuel to ease demand while shortages exist and, unfortunately, this requires that households incur the higher cost of automotive fuel.

There are many other supply-side taxes and subsidies that apply to businesses that governments can activate (see the recent report by the International Energy Agency for a review). While such policies can’t alter the initial hit from higher oil prices, they can mitigate the pass through to the economy and thereby mitigate pressure on the RBA to raise interest rates.