The primary transmission mechanism of greater tensions in the Middle East region to the global economy would be through higher energy prices, writes David Rees, senior emerging markets economist at Schroders, who adds that the price of Brent crude has already climbed over the past week – hitting around $91 at the time of writing – amid rising concerns that disruptions to supply from the region could conceivably push prices much higher in the future.

After all, tensions in the region have in the past caused global oil prices to climb substantially – the 1970s being the most dramatic example when prices quadrupled as the region descended into war.

Stagflationary outcome?

We track the risk from a supply shock in the “higher commodity prices” scenario that was published in our latest Economic and Strategy Viewpoint. That scenario was predicated in large part on production cuts by the OPEC+ group of fossil fuel exporters driving Brent up to $120 per barrel, which would push the global economy in a stagflationary direction from our baseline.

Higher commodity prices lead to an increase in inflation, while the risk of second round effects (ie. rising wages and prices) against a backdrop of tight global labour markets would tip the balance at central banks towards some additional rate hikes. Those lingering concerns about ingrained inflation would also delay the eventual pivot to rate cuts until later in 2024, meaning that monetary policy is more restrictive throughout next year.

Tighter monetary policy and a squeeze on households from higher commodity prices would result in slower growth, creating a stagflationary outcome.

The fading effects of past increases in energy prices following Russia’s invasion of Ukraine in early 2022 have been a key driver of global disinflation over the past year. But that trend had already begun to go into reverse before recent tragic events. Indeed, as the chart below shows, G7 energy inflation actually climbed from -8% YoY in July to -1% YoY in August.

Even if oil prices remained at their current level of $91 per barrel, energy inflation would turn positive into next summer before fading away in the second half of 2024.

Oil prices need to climb much further to derail the steady decline in headline inflation.

Energy inflation

Tight labour markets, as underlined by the September payroll growth in the US and a fresh historic low in the eurozone’s unemployment rate in August, mean that any sustained increases in inflation could eventually feed through to wage settlements and cause inflation to be stickier for longer. With the Fed already opening the debate over a final rate hike in its latest dot-plot, concerns about second-round effects could easily tip the balance towards another hike in November if oil prices climb further.

However, the immediate threat to broader inflation from higher energy prices should not be overstated. Indeed, our analysis shows that energy prices account for only 1,7% of core CPI, meaning that the direct impact of higher oil prices on underlying inflation would be minimal.