Energy shocks are rarely confined to energy markets. They propagate through bond markets, fiscal balance and inflation expectations, says Helen Thomas
As Winston Churchill once warned: “The statesman who gets war fever must know that once the signal is given he is no longer the master of policy, but the slave of unpredictable and uncontrollable events.”
The conflict in Iran has already affected global markets. Oil prices have risen, bond yields are rising and traders are quickly reassessing the outlook for inflation and interest rates. The risk is not simply a temporary increase in energy costs. It’s a return to what policymakers hoped was ultimately buried after the pandemic: rising inflation.
The International Monetary Fund has already warned about the level of risk. The agency’s chief Kristalina Georgieva said on Monday that a sustained 10 percent increase in oil prices, the most sustained of the year, would add about 40 basis points to global inflation.
It’s a meaningful shock to an economy where central banks have struggled to re-anchor inflation expectations for the past two years. About a fifth of the world’s oil passes through the Strait of Hormuz. After the painful experience of post-pandemic hyperinflation, even a relatively small energy shock can quickly ripple through wages, prices and financial markets.
leaning on
Some governments still have policy space to prevent blowouts. IMF chief Georgieva urged countries to use whatever buffers they have to manage the shock, provided they can rebuild later. South Korea is already considering lower oil prices to hurt households.
But not every country has this flexibility. For economies weighed down by weak growth and large debt piles, market volatility can quickly become a financial problem.
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England provides a clear example of this vulnerability.
In the Office for Budget Responsibility’s spring forecast update, the almost complete improvement in 10-year gilt yield assumptions since the autumn budget has already been wiped out by recent market movements. In fact, the interest rate relief that the government had quietly enjoyed disappeared as quickly as it arrived.
Rachel Reeves still used Spring’s prediction statement to argue that her financial strategy was working. She highlighted that next year’s debt interest is expected to be around £4bn lower than forecast in the autumn and suggested that if UK borrowing costs return to the G7 average there will eventually be around £15bn a year available for other priorities.
But the numbers that support this claim are far less convincing than the rhetoric suggests.
The £15bn figure appears to come from an OBR sensitivity analysis which shows that a one percentage point change in gilt yields will move borrowing by almost that amount. The result is that if yields fall back towards international counterparts, the government will receive a larger share of financial activity.
The problem is that markets move in both directions, and often quickly. In the week since the spring forecast, the 10-year gilt yield has already reached about 40 percent of that one percentage point range. When borrowing costs can change dramatically over the course of days, building a financial narrative around reasonable yield assumptions seems increasingly untenable.
Nor has the government used its limited breathing room to strengthen public finances. Reeves highlighted the £4bn savings on debt interest already effectively absorbed by policy measures announced since the Autumn Budget. Financial space that might have acted as a buffer against external shocks has already been consumed.
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It’s not just fiscal policymakers who face challenges. Monetary policymakers must contend not only with higher rates, but also with their psychological effects in the form of inflationary expectations. People are worried about rising inflation after Russia’s attack on Ukraine, when prices briefly rose to double-digit rates in many advanced economies. The event has made households increasingly wary of rising energy costs and skeptical of the central bank’s assurances that inflation will soon return to target.
Inflation expectations are important precisely because they influence behavior. If households expect inflation to rise again, they demand higher wages and bring up spending. Businesses respond by raising prices. The result can be self-reinforcing.
Markets are already beginning to reflect this risk, with the Bank of England, the European Central Bank and even the traditionally Swiss National Bank likely to raise interest rates rather than cut them.
The Bank of Japan may welcome this change. Governor Kazu Oda has indicated that he wants to continue normalizing interest rates after decades of ultra-loose policy. But Japan is particularly vulnerable to the energy shock that is now unfolding.
About 95 percent of Japan’s crude oil imports come from the Middle East. To mitigate this risk, Japan has expanded its strategic oil reserves to cover about 204 days worth of imports. This provides some reassurance but is hardly a permanent solution if the chaos persists.
Nor is the Strait of Hormuz just an oil story. The shipping line is also an important route for liquefied natural gas and key industrial commodities including urea, ammonia and sulfur.
Barriers to fertilizer markets are particularly important. When fertilizer prices rise, the effect eventually trickles down to farm costs and ultimately supermarket prices. What begins as a geopolitical shock in the Gulf can therefore manifest as higher food bills in Europe months later.
This is the overarching lesson of the present moment. Energy shocks are rarely confined to energy markets. They propagate through bond markets, fiscal balance and inflation expectations.
Eliminating Ayatollahs can be a spark. But the financial chain reaction unfolding now will eventually be felt at the local petrol pump and supermarket checkout far from Tehran.
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