Theme of the Day: How will the Iran war affect the global economy? – Capital Economics

In economic terms, the mechanism through which energy shocks operate is straightforward. Higher energy prices alter what economists call a country’s terms of trade – the price of its exports relative to its imports. When energy prices rise, income is transferred from energy-importing countries to energy exporters. The economic consequences of that transfer depend on three factors: whether a country is a net importer or exporter of energy; how large and persistent the price rise proves to be; and how governments, households and businesses respond to the shift in income. Duration is key: The scale and persistence of the energy shock will ultimately determine the macroeconomic impact. For energy-importing economies, the main transmission channel is likely to be via inflation. Higher oil and gas prices raise the import bill faced by households and firms, squeezing real incomes and eroding purchasing power. Recent signals provide some hope that the conflict may not last long. If so and provided there is no lasting damage to energy production facilities, the recent spike in oil prices to above $100/bbl would likely prove temporary, allowing most advanced economies to absorb the shock without significant disruption. As oil prices fall back, inflation in Europe and Asia in 2026 would likely be only around 0.5 percentage points higher than pre-conflict forecasts. Under this scenario, central bank strategies would remain largely unchanged, and the impact on real GDP growth would be minimal. A more severe scenario in which the conflict persists for several months could see oil prices rise to around $130/bbl before declining in the second half of the year. At a global level, the hit to growth would be modest, though the impact would be felt unevenly across regions. The euro-zone economy would probably contract in Q2 and then flatline over the second half of the year. The US economy would fare better but would nonetheless experience a slowdown in growth. Despite the weaker growth outlook, the accompanying rise in inflation would likely force central banks to shift policy. The Fed could abandon rate cuts while the ECB could move to raise interest rates. A conflict lasting three months, but with longer-lasting damage to capacity, notably to Iran’s Kharg Island. The estimate here is of a loss of 8-9% of world exports of oil and LNG, with an impact into 2027. Oil prices could hit $150/bbl and prices of gas in the EU (per megawatt hour) could hit €120. In the most severe case, a prolonged conflict with major damage to regional energy infrastructure pushes the global economy into stagflation, putting renewed interest rate hikes on the table. Growth would surely suffer. But, for reasons Paul Krugman spells out for the US, even the worst scenario would be nowhere near as economically damaging as the shock of the late 1970s. One reason is that our economies have become far less oil intensive since then. Europe has also shown itself far better able to adjust to higher gas prices than feared when the Ukraine war started. Another reason is that central banks have done a far better job of anchoring inflation expectations since they learnt the lessons of the 1970s.