- Even an imminent opening of the Straits of Hormuz won’t allay market concerns.
- The risk of shutdown would loom over energy prices.
- Consumers, already burdened with cost-of-living concerns, are likely to react quite adversely.
- But the fiscal room to shield them is constrained in most countries.
- Most central banks will refrain from hiking rates to combat this supply shock.
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Commentary: Shadow of stagflation
Can an isolated supply crunch amid muted global demand be sufficient to create an episode of stagflation? While the ongoing conflagration in the Middle East war is commanding blanket coverage and a wide range of energy and agriculture prices have spiked, the fact remains vast majority of global energy and petrochemical supplies are traded outside the Middle East. From Australia to the US, Russia to Western Saudi Arabia, Latin America to Africa, a wide dispersion of geographies supplies four-fifths of the world’s oil and gas. With global production facilities reducing their carbon intensity in recent decades due to various applications of clean tech, an energy shock packs relatively less bite than it would have had in the 70s or 90s.
But supply availability notwithstanding, energy prices are determined on the margin, and hence the stress out of the Straits of Hormuz would be felt worldwide. It is already evident that the spillover is extensive, as oil and gas go into the production of just about everything in the modern consumption basket, from electricity to plastics, fertilizer to chemicals. Even if shipment through the Straits of Hormuz resumes in the near term, the damage may already be done. Markets will have every reason to believe that disruptions could resume anytime, given the highly asymmetric nature of the damage that can be inflicted by low-cost drones against costly defensive manoeuvres. Also, oil doesn’t need to go much higher; even at $100-110, it would have material impact on the 2026 growth and inflation baseline forecasts.
Our worries are less about growth and more about inflation. Global growth dynamic was solid coming into this crisis, and these levels of energy prices are not sufficient to create major demand destruction. Looking at trade and production data from the first two months of the year, there is sufficient economic momentum in place to carry forward for a couple of quarters at least, in our view.
Inflation is a greater challenge. Consumers respond more to the change in the level of prices over several years than the year-on-year change numbers typically analysed by economists and followed by markets. When they see energy and food prices jumping on top of the 30-40% increase in the price level they have experienced since the pandemic, consumers’ sense of well-being is affected considerably. This is particularly the case for those in Australia, Japan, and the US, where inflation is running well above target already.
The whiff of stagflation would be challenging for policy makers along multiple dimensions. For central banks, hiking rates would be problematic as supply side inflation is typically hard to confront through a blunt instrument like interest rate. For fiscal authorities, preventing the passthrough of fuel prices through subsidies to energy marketing companies could prove to be unsustainable, especially as so many economies are already characterised by onerous public debt burdens.
Our stress scenarios around elevated energy prices remain unchanged (see analysis here). Our policy forecast is for most country authorities to refrain from substantially accommodating measures, be it monetary or fiscal, but also not make attempts at demand destruction for the time being.
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