TheMarketForIdeas

The war in the Middle East has already had a strong impact on energy prices, particularly those of oil and natural gas. It is therefore reasonable to expect that inflationary pressures will intensify in the period ahead. Beyond these inflationary effects, however, everything ultimately depends on how the conflict evolves – and on that point the greatest uncertainty prevails.

Three scenarios nevertheless appear plausible. The first would involve a return, after several weeks, to the previous equilibrium in hydrocarbon markets. The second would consist of a prolonged period of political uncertainty in Iran, leading to a relatively modest but persistent increase in the prices of oil and natural gas. The third scenario would involve severe and lasting tensions affecting global oil and gas supplies.

The latter two scenarios would amount to a stagflationary shock for the world economy: slower economic growth combined with rising inflation. Yet global economic growth had remained relatively robust in the period preceding the outbreak of the conflict. Moreover, inflation in most economies had been broadly under control, allowing central banks to avoid reacting hastily. Consequently, even under the second and third scenarios, global growth would likely slow sharply but remain positive, while central banks might not be compelled to tighten monetary policy further. Nevertheless, given the latent fragility of financial markets – already visible in the weeks preceding this major geopolitical shock – prudence is clearly warranted.

The reaction of oil and natural gas prices to the outbreak of the war involving Iran was immediate and dramatic. At the time of writing, oil prices had climbed above 107 dollars per barrel, while natural gas had reached around 3.4 dollars per MMBtu. This increase might have been even greater, were it not for the fact that prior to the conflict the supply of oil and gas had exceeded demand, exerting downward pressure on prices.

At the same time, energy markets appear to treat the current shock as non-structural. Indeed, on the eve of the conflict Iran was already subject to severe sanctions – unlike the situation faced by the European Union at the moment of Russia’s invasion of Ukraine, when the EU subsequently decided to eliminate its heavy dependence on Russian oil and gas imports.

Even so, the outcome of the conflict in the Middle East remains highly uncertain. Under all scenarios, at least a temporary impact appears inevitable. The possibility of a rapid de-escalation still exists and would lead, within a few weeks, to the first scenario outlined above. Yet that possibility appears to be diminishing rapidly, increasing the likelihood of the other two scenarios.

According to estimates by the International Monetary Fund, a 10 percent increase in oil prices – if sustained over the course of a year – would raise global inflation by an average of 0.4 percentage points while reducing global economic output by approximately 0.1-0.2 percent.

The exposure of different countries to energy shocks depends primarily on two factors: the share of energy in domestic price structures and the country’s energy balance. In general, rising energy prices affect inflation and interest rates and therefore influence consumption and investment. External balances – both the trade balance and the balance of payments – are also affected.

From this perspective, countries in Europe and Asia appear the most vulnerable. Even so, the fundamental macroeconomic parameters of these economies remain sufficiently strong to absorb the anticipated increase in energy prices.

By contrast, South American countries appear somewhat less directly affected by energy price shocks. However, their macroeconomic fundamentals tend to be more fragile, and their position within the economic cycle is generally weaker than that of other world regions.

Within the euro area, increases in fuel prices have already begun. The ultimate impact of rising energy prices will depend on the duration of the shock – whether it proves permanent or temporary –, as well as on the speed with which these increases feed through into core inflation. That transmission speed, in turn, depends on the broader economic context: the pace of economic growth, inflation expectations, the degree to which those expectations remain anchored, and the presence of other factors pushing inflation upward or downward.

Under these conditions, energy prices in Europe are likely to rise in two stages: immediately in the case of fuels, and more gradually in the case of natural gas and electricity. Growth rates will also differ across euro area countries, reflecting fixed-price contracts with varying revision dates as well as national regulations, which often play a significant role in shaping price dynamics.

Experience since 2022, when Russia launched its full-scale invasion of Ukraine, has shown that European governments can intervene to mitigate rising energy prices through taxation or subsidies. Should such measures be implemented again, their effect on prices would be significant but limited. Moreover, given that inflation in the euro area currently remains below target and inflation expectations appear relatively well anchored, the European Central Bank may not need to raise interest rates. Under the third scenario, however, a policy response from the ECB would likely become necessary.

In Romania’s case, the impact on inflation could likewise remain limited – provided that the oil shock does not spill over into the prices of agricultural and food products. Romania’s economy is currently in a phase of technical recession, in which the gap between actual and potential GDP is negative. Under such conditions, inflationary pressures are unlikely to multiply through the economy.

Furthermore, the depreciation of the leu has remained moderate, largely due to interventions by the central bank – approximately 2.5 percent at the time of writing. Nonetheless, Romania currently records the highest inflation rate within the European Union, which makes it, a priori, the European country most exposed to additional inflationary pressures.

It should also be noted that in Romania the combined share of taxes, duties, and excise charges in the final price of fuel amounts to roughly 50-60 percent. This dominant fiscal component provides a certain margin of maneuver within which the government, importers, and producers can influence final retail prices.

In a recent speech delivered at an economic event in Japan, IMF Managing Director Kristalina Georgieva sent governments a simple message: “Think about the unthinkable – and prepare for it.” In an increasingly unstable world, she argued, policymakers should focus on three elements that remain within their control: strong institutions and sound economic policies; financial buffers for difficult times; and the capacity for adaptation.

Photo source: PxHere.com.