Oil price shocks derail globaleconomy

Global economies are facing a familiar risk, stemming from a conflict-induced energy price shock that threatens to propel inflation, maintain high interest rates, and damage growth. Investors are now concerned that central banks may delay anticipated rate cuts due to renewed rises in energy prices linked to the ongoing war in the Gulf.

Predictions indicate that Brent crude, the international benchmark, could surpass $100 per barrel if the Strait of Hormuz, a vital shipping chokepoint for global oil trade between Iran and Oman, remains effectively closed for an extended period. The surge in gas prices, which countries like the UK heavily rely on, adds to inflation concerns as economic repercussions become more pronounced.

Much like fifty years ago, the UK continues to be a net energy importer, making it vulnerable to the inflationary and growth-reducing effects of increased oil and gas prices. As global energy prices rise, traders have reduced their expectations for the Bank of England to cut interest rates at its upcoming meeting on March 19, lowering the probability to approximately 30 percent.

The yield on the two-year UK government bond, often viewed as a barometer for traders’ rate expectations, has jumped by 0.17 percentage points to 3.7 percent over the same timeframe. According to James Smith, a developed markets economist at ING, if energy prices sustain their current levels, UK inflation could peak at 3.5 percent in the spring, leading to a likely delay in the Bank of England’s rate cut until April.

Just a month ago, the central bank projected that UK inflation would fall back to its target of 2 percent in the spring and remain there through to 2029. Market speculation surrounding the Federal Reserve’s rate cuts has also diminished, with some analysts suggesting that the European Central Bank may even contemplate raising borrowing costs.

The Asia-Pacific economies would bear the brunt of an outright closure of the Strait of Hormuz, as much of their oil supply traverses the strait. In comparison, Western countries have relied on US shale oil, which saw a production boom during the 2010s. Notably, approximately 75 percent of Japan’s oil imports pass through the Gulf, while South Korea sources around 60 percent of its energy from this route. China relies on the strait for about half of its crude imports.

Despite the current rise in oil prices being nowhere near the drastic elevations seen during past crises, such as the 1973 Arab oil embargo or the 1979 Iranian Revolution, sustained increases will have significant inflationary repercussions. Since last Friday, Brent crude has surged from $73 to $81 per barrel, while the US benchmark West Texas Intermediate has climbed from $67 to $74. Past oil price surges during events like the 1990-91 Gulf War and Russia’s invasion of Ukraine in 2022 have mirrored the recent price increases.

Analysts from Goldman Sachs warn that if the Strait of Hormuz undergoes a prolonged shutdown lasting five weeks, oil prices could again breach the $100 mark for the first time since 2022, highlighting considerable risks to the market.