Energy prices and the risk of stagflation

Oil prices have been extraordinarily volatile, but have risen sharply as about 20% of the global trade in oil will be out of action for some time. In real terms, oil prices are currently about 30% higher than last month.  Prices have fluctuated wildly, with the gains at times echoing the first Gulf War, but still smaller than the two oil shocks of the 1970s.

LNG prices have risen by more, currently up about 50% in the wake of Qatar – which is one of three almost equal-largest exporters of LNG globally, along with Australia and the US – halting production. This increase broadly matches the spike seen during the first Gulf War.

Estimates of the duration of the war also vary wildly and it is highly uncertain when energy supplies will return to normal.  President Trump has said that the war would be over "soon, very soon", whereas Secretary of Defense has said, "[the public needs to]  understand [that] this is only just the beginning".  Meanwhile, reports from Israel have canvassed the war running for much longer than originally thought.  

If the war continues and there is a large sustained increase in energy prices, then there will be a big and immediate boost to headline inflation.  Arbitrarily assuming a sustained 20% increase in retail fuel prices - which is similar to the spike seen in the early 1990s – the boost to headline inflation would  be about ½pp in the US, almost 1pp in the euro area, and about ¾pp in Australia. The same-size shock to all gas prices would raise headline inflation by less than ¼pp in the US, about ½pp in the euro area and ¼pp in Australia (euro area households have a greater direct reliance on gas). 

These potential direct effects are lower bounds because eventual indirect effects of a sustained shock – for example, food prices increasing on a higher cost of fertiliser, airlines introducing fuel surcharges, and higher electricity prices – would be significant. 

The modelled impact of energy prices on core inflation is usually small and sometimes negligible, although that would change if inflation expectations drifted higher, as higher expected inflation would have a roughly 1:1 impact on core inflation.

More generally, a sustained energy shock would be recessionary for the advanced economies, where IMF research has shown that "recessions associated with a severe oil price shock [are much worse] than recessions without an oil price increase".  Such recessions are also stagflationary given higher headline inflation.   

In such a scenario, higher headline inflation would reduce the purchasing power of households, acting as a tax on consumer spending.  A sustained shock would also cause firms to curb investment and hiring.  Budget deficits would deteriorate, although less clearly in Australia, which would see higher commodity earnings given it is a net exporter of energy where long-term contracts are mostly indexed to current prices.   

A stagflationary outcome would pull central banks in opposing directions.  Central banks mechanically react to higher unemployment by quickly cutting interest rates, but they will be worried this time that a sustained increase in energy prices could spill over to inflation expectations, particularly when inflation is still above target in almost every country.

Expectations across the advanced economies have been anchored by central bank targets for many years now, weathering both low inflation post the global financial crisis and high inflation during COVID. 

If expectations drifted higher, something that last happened in response to the energy shocks in the 1970s, policy rules suggest policymakers should raise rates by more than the increase in expectations. In such a scenario, this effect would offset, either partially, in full, or more than fully, the signal to cut rates from higher unemployment.