The long and the short: Part 1

As the US-Israeli war against Iran drags into its sixth week, the repercussions will be far-reaching. In the near-term, these are likely to be primarily economic. In the longer-term, the geopolitical ramifications will be more profound as the global order experiences what appears likely to be a permanent rupture. In the first part of a two-part note, I take a look at the economic aspects – drawing on an interactive VAR simulation dashboard to map the transmission of shocks – while the second part (forthcoming) will deal with the geopolitical consequences.

The magnitude of the problem

IEA Executive Director Fatih Birol, recently warned that “we are heading towards a major, major disruption, and the biggest in history.” It is almost certain that market conditions will get worse before they get better. Oil supply in March was partially supported by cargoes that had already passed through the Strait of Hormuz before hostilities escalated, and oil prices are already up 50% compared to pre-hostilities levels. If current estimates are correct that disruptions amount to 12 million barrels per day, this would amount to a 12% cut in global crude supply on an annual basis, compared to reductions of less than 5% in the 1970s. To put that into context, oil prices tripled – both in real and nominal terms – in 1974.

In an ironic twist, the 1970s oil shock was prompted by unconditional US support for Israel during the Yom Kippur war, which angered other Arab States so much that they imposed an oil export embargo. This led to increased tension between the US and several of its European allies who privately criticised the US for its reckless policy actions. US Secretary of State Henry Kissinger later admitted: “I made a mistake. In retrospect it was not the best considered decision we made.” It is unlikely that Donald Trump would ever make such an admission.

That was then. In many ways the world is very different. For one thing, although global oil consumption has doubled since the 1970s, European consumption in terms of barrels per day has remained broadly flat whereas Asian demand has increased fourfold, resulting in a big decline in consumption share for the former and a big rise for the latter (chart above). This is partly a reflection of European deindustrialisation whereby Europe now imports a lot of the manufactured products from Asia that previously would have been produced domestically. This has a double-edged effect: Asia will likely be much harder hit by the recent surge in oil prices than it was in the 1970s, while Europe will still end up importing inflation. Nor is the story these days purely about oil. Natural gas is increasingly used as a form of power generation, with global consumption having increased by 3.5x since the 1970s while European demand is up by 2.5x. So far, natural gas prices have not spiked to the same degree as they did in 2022: The Daily System Average Price (SAP) of Gas in the UK, which is an important determinant of retail prices, is admittedly up by 80% since end-February, but at 4.73p/kWh it is well below levels in excess of 19p/kWh in summer 2022. That said, matters might look different in a few months if energy does not start flowing through the Straits of Hormuz soon.

As it is, the pump price of petrol has risen sharply. US prices are now around $4/gallon, still 20% below the highs of summer 2022, but not a prospect that will endear President Trump to voters ahead of the mid-terms due in November (charts below). Similar trends are evident in the UK with a price around £1.54 per litre still 20% below 2022 highs (though at £5.83 per US gallon, or $7.59 at current exchange rates, UK motorists pay a lot more to fill up their cars). The price of petrol will feed through quickly into inflation. A rough rule of thumb is that every 5p on the fuel price adds 0.1pp to UK inflation, so on the basis of mid-March prices that will add 0.2pp to last month’s inflation rate. Latest data point to another 0.3pp in April. In the absence of energy effects, we could have expected UK April inflation to fall to the BoE’s 2% target rate as a number of base effects drop out of the calculations. On my calculations, that now looks unlikely.

Back in 2022, the huge surge in global prices triggered big increases in domestic energy bills. In the UK, domestic gas prices rose by 130% in 2022 though they are currently 35% below those peaks. In the short-term, consumers will be sheltered by the quarterly fixing of the household energy cap in April which means that any rise in domestic prices will only start to feed through from July. The econometric evidence suggests that it takes around 6 months for the full impact of global prices to feed through to UK consumers, which means we can expect significant increases in household energy bills in the latter part of 2026. On my calculations, the increase is likely to be at least 50% by end-year – and probably higher.

How do policymakers respond?

Even if we assume that the war ends tomorrow, the supply disruptions will take months to unwind, and it could take until end-year before supply is back to normal. But this optimistic scenario is one of the least likely options given the rhetoric out of Washington and Tehran in recent days. To frame the scale of the challenge facing policymakers, I have built an interactive VAR simulation dashboard (here) that allows users to explore how oil shocks and related variables propagate through the US, UK and euro area economies. It is not intended as a forecasting tool, but it provides a clear, model‑based sense of the pressures policymakers – particularly central banks – will have to weigh as they confront the next phase of this crisis[1].

The most obvious question is whether central banks should respond to inflationary shocks by tightening policy. In 2022, central banks responded to higher oil prices by raising interest rates. In one sense they could afford to do this because at the time of the Russian invasion of Ukraine, interest rates were at their effective lower bound. There was, in short, scope to tighten policy. Interest rates today are much closer to neutral. The extent to which rates should rise thus depends upon the extent to which second round effects are likely to impact the economy. In the US, the degree of labour market slack as measured by the unemployment rate is only modestly higher now than in early 2022. But in the UK the unemployment rate currently stands at 5.3% and rising, versus 3.9% and falling in early-2022. The number of  unfilled vacancies in the UK has fallen, suggesting softening demand for labour. All told, the risk of second round effects might be smaller than four years ago. The simulation model suggests that a sustained 50% rise in oil prices will add around one percentage point to UK inflation, and raise the risk of a modest 25bps increase in interest rates (50bps if we use the regime switching option). The ECB would be expected to respond with a 50bps rate hike whereas the Fed may even respond by cutting rates (charts below).

The other question is whether governments will be able to afford to use fiscal means to cushion households against rising energy bills in the way they did in 2022. In the UK, the net cost of support measures was roughly 2% of GDP in fiscal 2022-23. Hopefully the spike in the household energy price cap will be nowhere near as big as four years ago. Even so, a government which has set out its stall to balance the fiscal current account by the end of the decade will have precious little scope to provide any form of support. Indeed, as a senior British lawmaker put it to me recently, there is a question of whether governments should be providing such levels of support at all.

Last word

We can debate the pros and cons of Trump’s war (let us call it for what it is) but the economic consequences are unavoidable. A supply shock of this scale cannot be insulated by monetary policy or fiscal transfers. It will impact on prices and is likely then to affect wages and public finances, testing the political and economic cohesion of the global economy. The uncomfortable reality is that the costs will fall disproportionately on households and regions that had no role in shaping the decisions that triggered the crisis. The extent to which electorates are willing to absorb those costs is one that policymakers can no longer ignore.

---

[1] The model includes GDP, CPI, the central bank policy rate and the trade weighted exchange rate (UK and euro zone)/unemployment rate (US). Users can simulate the impact of oil price changes; change the number of periods over which the disruption lasts; the pace of return back to baseline; the forecast horizon and whether they wish to operate in a low or high price regime. Separately, users can simulate the effects of changing endogenous variables with oil prices fixed. Please note that this is a work in progress. See the webpage for more detail.