War in Iran: what to expect for the global economy

Raphael Olszyna-Marzys, international economist at J. Safra Sarasin Sustainable Asset Management, examines what the Iran conflict could mean for the global economy and the outlook for inflation and interest rates.

Many of the Iranian regime’s senior figures have been killed in the US-Israeli air strikes over the past few days. Even so, the Islamic Revolutionary Guard Corps (IRGC), the regime’s backbone, is unlikely to capitulate. The American administration – facing midterm elections in November and scant public support for the war, including among its own MAGA base – has limited time. Tehran knows this. Its strategy appears to be to play for time while raising pressure on Washington by pushing up oil prices and drawing Gulf states and other US allies deeper into the conflict.

Strikes inflict sufficient damage for administration to end campaign within weeks

At the same time, the strikes are likely to inflict substantial damage on Iran’s nuclear and ballistic-missile programmes in the coming weeks. At that point, the administration will be able to claim victory, even if conditions on the ground remain fluid. What remains of the regime – probably under tighter control, at least initially, by the IRGC – will retain some military capability and the ability to strike across the region with drones, against which neither the US nor Israel has a good answer. Once the war’s hottest phase ends, some form of negotiation will therefore be unavoidable. In the meantime, the US, perhaps with the help of partners, will need to restore energy flows through the Strait of Hormuz – through naval escorts and state-backed insurance for tankers – to keep prices contained.

Oil price to settle at $75/bbl

In our central scenario, oil prices remain between $80 and $90 per barrel (bbl) in the coming weeks before settling around $75/bbl, with a geopolitical risk premium keeping prices above their pre-conflict level. This implies oil prices averaging roughly 15% higher over the next 12 months than over the previous year. What might this mean for the global economy?

Modest rise in inflation and fall in GDP growth in advanced economies

Most estimates suggest that a 15% rise in oil prices would add about 0.2-0.4 percentage points (%pts) to headline inflation over the coming year and trim GDP growth by 0.1- 0.3%pts, with net-energy importers such as the euro area and Japan at the upper end. The impact on core inflation tends to be much smaller – between 0.075-0.15%pts. Even so, there are reasons to think the effect could be closer to the lower range of those estimates. To see why, it is worth considering the transmission channels.

A higher oil prices impacts inflation

Oil prices influence inflation in two ways: directly, through household spending on energy such as fuel; and indirectly, through higher production costs and second-round effects, including wage increases and shifting inflation expectations. A recent paper by the Fed covering 27 advanced economies finds that direct energy consumption accounts for just over 60% of the initial impact, with indirect effects making up the remainder.

A range of factors explain the difference in magnitude and persistence

The scale and persistence of the pass-through depend on several factors: the share of energy in household spending; tax and subsidy regimes; energy dependence and exchange-rate movements; labour-market institutions; central-bank independence and inflation-targeting frameworks; the state of the business cycle when the shock occurs; and the nature of the shock itself.

Inflation sensitivity to oil shocks has reduced over time

Labour-market liberalisation, the decline of collective bargaining and the fading of wage indexation have all reduced second-round inflation effects in recent decades. Stronger central-bank independence and the widespread adoption of inflation targeting have probably played an even bigger role by anchoring inflation expectations more firmly. This is particularly true in advanced economies, which also tend to have lower energy intensity and smaller currency depreciations during terms-of-trade shocks. As a result, most research finds that inflation has become less sensitive to oil prices over time, especially since the 1990s. 

Inflationary impact likely to dampen

In the current episode, there are further reasons to expect a more modest impact. First, most advanced economies are operating with a small negative output gap, with the exception of the US. That should limit second-round effects. Second, the rise in energy prices reflects a negative supply shock, which studies show have a smaller inflationary impact than if the rise in prices reflects stronger aggregate demand. This makes intuitive sense: households ultimately have less disposable income to spend on other goods and services, which tends to dampen price pressures elsewhere in the economy.

The passthrough on euro area and UK inflation larger than for the US 

The impact also varies across countries. Some studies suggest that pass-through in Europe is somewhat larger than in America, though the evidence is mixed. One reason is that energy carries a larger weight in European consumer-price baskets and is subject to higher fuel taxes, both of which amplify the effect of oil price increases. As net energy importers, European economies also tend to see their currencies depreciate when faced with negative terms-of-trade shocks, as seen in recent days, adding to inflationary pressure. More regulated energy markets, however, can initially delay the passthrough – though this may prolong its eventual impact, particularly on core inflation.

European natural gas prices rising more than in the US

Another important consideration, highlighted during the war in Ukraine, is the impact from natural-gas markets. The shock was far more severe in Europe than in the US because of Europe’s reliance on Russian gas, and with electricity prices being tied to the provider’s marginal cost. Europe’s dependence on Middle Eastern gas, as well as low inventories, explains why spot prices in recent days have risen more than in the US.

Muted impact on inflation in Switzerland 

Switzerland, by contrast, tends to experience one of the lowest pass-through rates. Energy has a relatively small weight in its inflation basket; the Swiss franc often appreciates during global shocks; and the country benefits from a highly credible central bank and limited wage indexation.

Modest effect on GDP growth overall

The effect on GDP growth should be modest overall, though larger in net energy-importing economies, such as the euro area and Japan. For them, higher energy prices represent a negative terms-of-trade shock that reduces real national income. The opposite holds for the US, a net oil exporter. American consumers will still suffer from higher fuel costs and lower real disposable income. But the economy should nonetheless fare better than Europe’s, as higher prices could spur increased oil production and investment in the oil and gas sector. Heightened geopolitical uncertainty may also weigh on activity, though the marginal effect is unlikely to be large.

Central banks to delay rate cuts 

What, then, will central banks do? Most will probably wait and see. Monetary authorities typically look through negative supply shocks, which initially push inflation up but ultimately dampen output – and therefore inflation. The effect on core inflation, a better guide to future headline inflation, should be limited. Even so, policymakers are unlikely to be entirely relaxed. With the exception of Switzerland, headline or core inflation remains above 2% in most large economies, and household surveys, such as in the UK, show long-term inflation expectations still above central-bank targets. If our central scenario proves to be correct, however, the shock should be quite modest and short-lived. Rate cuts may be delayed, but outright rate rises still look unlikely.