What are the macro implications of the Middle East escalation?

Israel’s Prime Minister Benjamin Netanyahu promised retaliation and there are reports that Israel could target Iran’s oil production facilities. Up until now, the response of oil markets has been quite muted. The risk premium built into oil price benchmarks over recent days looks to stand at around USD 5-8 per barrel.

This reflects the starting point for oil markets. Global oil demand has slowed sharply over the last few months and the outlook for demand remains subdued. According to the IEA, demand is estimated to rise by just 900 kb/d this year, sharply below the rise of 2.3 mb/d recorded in 2023. Oil demand growth is seen at a similar rate next year. The sharp slowdown of China’s oil demand is playing a big role in these trends and the IEA signalled that ‘OPEC+ may be staring at a substantial surplus, even if its extra curbs were to remain in place’.

Meanwhile, reports suggest that the Saudi oil minister has been warning that some OPEC+ countries are not sticking to agreed-upon production limits, which could push oil prices as low as $50 p/b. OPEC+ currently plans to increase its production limits from December onwards, though this could still change.

However, recent developments could change the current subdued outlook for oil markets. Iran’s oil supplies were running at 3.4 mb/d in August according to the IEA. So significant damage to its production facilities does have the potential to reverse the balance in global oil markets. There is also the risk that there could be severe disruptions in Strait of Hormuz, which is estimated to handle almost 30% of the world’s oil trade. Against this background, there is significant potential for oil prices to rebound if the situation escalated, but the extent of course depends on which scenario plays out. In working through the macro implications, we consider the possibility of a jump in Brent oil prices to $90 b/d, which was roughly the peak we saw earlier this year.

What would this mean for European inflation and how would the ECB react?

Assuming Brent oil prices rise to $90 over the coming months - with occasional spikes even higher - this would push eurozone inflation back to near 3% over the coming months, which is around 0.7pp higher than our base case at peak. If oil then settles at this high level into next year, annual average inflation would be 0.3pp higher, at 2.3% in 2025 vs our base scenario of 2%. This is significant, and the ECB’s messaging would likely be cautious and vigilant given the recent experience with the energy crisis, and the risk that this could push inflation expectations higher again. However, on balance, we judge that it would be unlikely to derail rate cuts, for three reasons. First, as is visible below, the magnitude of such a hit to inflation pales in comparison to the impact of the energy crisis, which at its peak saw gas and electricity prices rising to some 15-20 times their pre-pandemic norm. It could be that the 20-30% rise in Brent that we assume is too low, but it is unlikely to be anything close to what was seen in the energy crisis.

Second, and related to this, the context is very different to late 2021 when the energy crisis started. Back then, economies were roaring back to life from pandemic lockdowns, and the surge in demand was meeting a heavily constrained supply side across the board - not just in energy markets. So, demand was generally strong, while supply was generally weak. We now find ourselves in the very opposite situation, with demand weak and our supply bottlenecks index well in abundance territory. As such, the chance of significant second round effects is much lower.

Third, and given the above, the forces acting on demand and inflation are likely to be more offsetting than in the recent period. Indeed, we estimate such a rise in oil would lead to growth being c0.2pp lower in 2025 compared with our base case. With growth already weak, and consumers still cautious, a renewed hit to real incomes is likely to have a more depressing effect on demand, which in turn would work to lower core inflationary pressure rather than to raise it. Thus, the upward impact from higher oil prices would be partly neutralised by weaker demand, in contrast to the amplification effects we saw during the energy crisis. Given this, while there may be a risk of a brief pause in rate cuts while the Governing Council assesses the situation, and the ECB would express vigilance, we judge a significant derailment of rate cuts to be unlikely.

What would this mean for the US economy and would the Fed react?

The scenario of $90 dollar Brent oil would also have an effect on the US, although the impact would likely be smaller compared to Europe, similar to how it played out in 2021-2022. In some ways, the US, which also exports substantial amounts of natural gas and crude oil, actually benefited from the high energy prices. The inflation impact in the US is expected to be qualitatively similar to the eurozone, with headline PCE inflation potentially increasing to 2.7% by year-end, and an average level that stands about 0.2 to 0.3 percentage point above the counterfactual scenario throughout 2025. The higher oil price may dampen economic growth somewhat, but the impact would be limited, and perhaps even imperceptible given the potential for other sweeping policy changes. Oil prices are simply a volatile component of inflation, more determined by outside events than by the policy rate, and therefore they carry less weight in central bank decisions. Given the fact that other inflationary pressures are easing, and that downside risk to the labor market remains elevated, it is unlikely that the Fed would be deterred from continuing the easing cycle that it initiated last month.