October 14, 2024 - 11:40am

With inflation in the eurozone falling to 1.8% in September from 2.2% in August, the consumer price index is now below the European Central Bank target of 2%. This has many speculating that we may be reverting back to the post-pandemic norm of very low inflation. The ECB’s monetary policy committee will meet this Thursday, and is now widely thought to be moving to cut rates by at least 0.25%.

Investors are also anticipating that this will be the first in a series of rate cuts. Jens Eisenschmidt, Chief Europe Economist at Morgan Stanley, told the Financial Times yesterday that he expects interest rates to be halved to 1.75% by December 2025. It is not hard to detect some excitement among investors and policymakers about these prospects. The inflation has been very difficult for both groups and a return to low rates and stagnation is a much more predictable, if somewhat depressing situation.

Yet this anticipation of low inflation may be premature. What we have learned in recent years — with inflation induced first by the lockdowns and then by the Ukraine war — is that the main drivers of rising prices are geopolitical events which are hard to predict. The Middle East is currently a powder keg, and if it explodes the effects on inflation might make the past three years look tame by comparison.

Consider that in 2022 Russia accounted for around 12.7% of global crude oil production. When the war in Ukraine started, Russian oil production did not get shut down. Due to sanctions, it instead had to be rerouted to other markets, and this disruption caused the price of Brent to rise to $133 a barrel in March 2022.

In comparison, the Middle East produced around 31.5% of global output in 2023 — or two-and-a-half times Russian oil production. What’s more, 20-30% of global oil production is shipped through the Strait of Hormuz. A disruption in the Middle East would not, as with the disruption to Russian supplies, simply result in oil being rerouted to other markets. Rather, it would cause an actual decline in oil production.

The extent of this decline would depend on how bad the situation got. At the extreme, Iran could impose a blockade on the Strait of Hormuz. This would likely result in a spiralling of the oil price that would be without comparison in modern times. When a similar embargo was imposed in 1973 by the Saudis, oil prices almost tripled from around $3.50 a barrel to around $10.20 a barrel.

A similar tripling today would produce prices of around $210 a barrel. Fluctuations in the price of oil often determine the rate of inflation, which means we can predict roughly how high inflation would go in such a scenario. If oil reached $210 a barrel, the inflation rate in the United States would rise to above 18% — making the previous peak of just over 8% look tame by comparison.

A blockade of the Strait of Hormuz would be an extreme outcome, however, and would provoke the Arab nations with whom Iran is trying to normalise relations. Even without a blockade, though, attacks on infrastructure in the Middle East could lead to significant increases in the oil price. Market nervousness about the situation in the Middle East has been enough to drive oil futures prices up from $65 a barrel last month to $74 a barrel today.

This raises the question of what a Donald Trump administration’s policy will look like in the Middle East. It is widely thought that the Republican candidate will give Israel more space to pursue its objectives in the region. Increasingly, these objectives look like they may include conflict with Iran. Yet, at the same time, Trump has campaigned on returning the American economy to normal after years of inflation under Joe Biden. The energy question could end up being the most important for an incoming Republican administration.


Philip Pilkington is a macroeconomist and investment professional, and the author of The Reformation in Economics

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