A sustained energy shock would raise the risk of recession

Oil prices remain extraordinarily volatile and are currently about 45% above pre-Iran-war levels as the market tries to estimate how long the Strait of Hormuz might be blocked. LNG prices are up by more because Qatar has halted production, currently about 70% above pre-war levels.

The war has reduced the world supply of oil by about 20%, with the world supply of gas down about 4%. The IEA release of 400m barrels of oil from reserves will cover the shortfall in the supply of oil for about 20 days, assuming full compliance, while some additional oil could be exported via existing pipelines. The US is seeking a more lasting military solution by trying to form a coalition of selected advanced economies and China to escort ships through the Strait of Hormuz.

Some central banks might release their modelling this week, but the IMF recently published its estimated impact of an oil price shock for advanced economies. Scaling the IMF analysis, a roughly 30% increase in the price of oil – which is what is currently factored into the futures curve for the rest of this year – would boost headline inflation by about 1¼pp. The risk to headline inflation seems greater this time around because the closure of the Gulf is likely to affect food prices via the reduced supply of fertiliser and goods prices via the lower supply of key industrial chemicals.

In this scenario, GDP would be around ½pp lower on the IMF’s figures. Based on the usual relationship between activity and the labour market, this points to an increase in the unemployment rate of about ¼pp, consistent with a sharp economic slowdown, but not recession.

As for the impact of higher oil prices on core inflation, past central bank analyses regularly show a small, sometimes negligible, effect, although that hinges on inflation expectations remaining anchored to inflation targets. Higher expectations would lead to sustained higher core inflation, which is why central banks are likely to talk tough about the upside risk to inflation posed by the war with Iran.

More generally, a sustained reduction in the world supply of energy points to an increased risk of recession. The world economy has become less dependent on oil over time, but growth in world GDP is still highly correlated with growth in the global production of both oil and gas, such that a long blockade of the Gulf would raise the risk of recession.

A US-led coalition of warships might change things, but Iran could continue to attack ships, hampering a return to pre-war shipping volumes. In this respect, it is worth noting that the Houthis have successfully reduced shipping volumes through the Suez Canal by about 60% since they first started attacking vessels with drones and missiles in late 2023.

If a recession is realised, an IMF study of business cycles shows that recessions associated with oil shocks are stagflationary, with both higher inflation and higher unemployment. In a “normal” recession, a central bank cuts rates aggressively, usually from a starting point of high interest rates. Stagflation greatly complicates things and a simple policy rule based on the usual increase in inflation and unemployment seen in an oil shock points to little change in interest rates.

Moreover, there is the clear risk that central banks nowadays would seek to avoid the policy mistakes of the 1970s, responding with higher interest rates if inflation expectations drifted higher.