Energy shocks rarely remain confined to energy markets. They propagate through bond markets, fiscal balances and inflation expectations, says Helen Thomas
As Winston Churchill once warned: “The statesman who yields to war fever must realise that once the signal is given he is no longer the master of policy, but the slave of unforeseeable and uncontrollable events.”
The conflict in Iran is already affecting global markets. Oil prices have surged, bond yields are rising and traders are rapidly reassessing the outlook for inflation and interest rates. The risk is not simply a temporary spike in energy costs. It is the return of something policymakers hoped had finally been buried after the pandemic: rising inflation expectations.
The International Monetary Fund has already warned about the scale of the danger. Managing Director Kristalina Georgieva said on Monday that a sustained 10 per cent rise in oil prices lasting most of the year would add around 40 basis points to global inflation.
That is a meaningful shock for an economy where central banks have spent the past two years fighting to re-anchor inflation expectations. Roughly a fifth of the world’s oil supply passes through the Strait of Hormuz. After the painful experience of the post-pandemic inflation surge, even a relatively small energy shock can quickly ripple through wages, prices and financial markets.
Cushioning the blow
Some governments still have the policy space to cushion the blow. The IMF’s Georgieva has urged countries to use whatever buffers they have available to manage the shock, provided they rebuild them afterwards. South Korea is already considering a cap on fuel prices to soften the blow to households.
But not every country has that flexibility. For economies weighed down by weak growth and large debt piles, market volatility can quickly become a fiscal problem.
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The UK offers a clear illustration of that vulnerability.
In the Office for Budget Responsibility’s updated Spring Forecast, almost the entire improvement in the 10-year gilt yield assumption since the Autumn Budget has already been erased by recent market moves. In effect, the interest-rate relief the government had quietly benefited from has disappeared almost as quickly as it arrived.
Rachel Reeves nevertheless used the Spring Forecast statement to argue that her fiscal strategy is working. She highlighted that debt interest next year is expected to be about £4bn lower than forecast in the Autumn and suggested that if UK borrowing costs returned to the G7 average there could eventually be around £15bn a year available for other priorities.
But the numbers underpinning that claim are far less reassuring than the rhetoric suggests.
The £15bn figure appears to come from OBR sensitivity analysis showing that a one-percentage-point change in gilt yields would move borrowing by roughly that amount. The implication is that if yields fall back towards international peers, the government will gain a large amount of fiscal headroom.
The problem is that markets move in both directions, and often very quickly. In the week since the Spring Forecast, the 10 year Gilt yield has already jumped by roughly 40 per cent of that one-percentage-point threshold. When borrowing costs can shift so dramatically in the space of days, building a fiscal narrative around favourable yield assumptions looks increasingly precarious.
Nor has the government used its limited breathing room to strengthen the public finances. The £4bn saving on debt interest Reeves highlighted has effectively already been absorbed by policy measures announced since the Autumn Budget. Fiscal space that might have acted as a buffer against external shocks has already been spent.
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It’s not only fiscal policymakers who face a challenge. Monetary policymakers must contend not only with higher prices, but their psychological impact in the form of inflation expectations. The public remains scarred by the inflation surge that followed Russia’s invasion of Ukraine, when prices briefly rose at double-digit rates in many advanced economies. That episode left households acutely sensitive to rising energy costs and sceptical of central bank assurances that inflation will quickly return to target.
Inflation expectations matter precisely because they influence behaviour. If households expect inflation to rise again, they demand higher wages and bring forward spending. Businesses respond by raising prices. The result can become self-reinforcing.
Markets are already beginning to reflect that risk, pricing in the possibility that the Bank of England, the European Central Bank and even the traditionally dovish Swiss National Bank may have to raise, rather than cut, interest rates.
The Bank of Japan may appear to welcome that shift. Governor Kazuo Ueda has signalled that he would like to continue normalising interest rates after decades of ultra-loose policy. But Japan is uniquely vulnerable to the energy shock now unfolding.
Around 95 per cent of Japan’s crude oil imports come from the Middle East. To mitigate that risk, Japan has accumulated a vast strategic petroleum reserve large enough to cover roughly 204 days of imports. That provides some reassurance but is hardly a permanent solution if disruptions persist.
Nor is the Strait of Hormuz simply an oil story. The shipping lane is also a critical route for liquefied natural gas and for key industrial commodities including urea, ammonia and sulphur.
Disruptions to fertiliser markets are particularly important. When fertiliser prices rise, the effect eventually feeds through into agricultural costs and ultimately into supermarket prices. What begins as a geopolitical shock in the Gulf can therefore reappear months later as higher food bills in Europe.
That is the broader lesson of the current moment. Energy shocks rarely remain confined to energy markets. They propagate through bond markets, fiscal balances and inflation expectations.
The removal of an Ayatollah may have been the spark. But the financial chain reaction now unfolding will ultimately be felt far from Tehran, at the local petrol pump and supermarket checkout.
By City AM
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