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Stagflation looms amid Middle East unrest

Federal Reserve Chairman Jerome Powell speaks at a press conference in Washington D.C. yesterday. Credit: Getty

August 1, 2024 - 10:00am

Anxiety gripped world markets after Israel’s successful hit jobs this week on Hezbollah and Hamas leaders in Lebanon and Iran. Oil prices leapt and bond yields fell in an apparent rush to safety among investors.

Markets had already been slightly on edge. Recent reports have suggested that the years-long boom in the American economy may be petering out, at a time when the other developed economies are struggling to get moving again. This earnings season has so far disappointed US investors, whose expectations of future growth were so stretched that some correction was overdue. Meanwhile, the AI euphoria is waning as hope about the future possibilities of this technology gradually gives way to doubts about the hype.

Reflecting this slowdown, oil prices had begun falling of late. Had that trend continued, it would have provided some fillip to consumers, easing any pain that might have come from a slowing job market. So if the American economy — which has been the one bright spot among the major economies — really is decelerating, a leap in the oil price will come at the worst possible time.

Although inflation has come down a long way in Western economies, it’s still not clear that the worst is past. As a result, a sharp rise in energy prices could, if sustained, make life difficult for central banks, stirring inflation back to life at the very moment the economy is slowing. The dreaded stagflation would rear its ugly head once more.

This tension won’t ease any time soon. The risk of an all-out regional war in the Middle East is now higher than it’s been in years — that is especially the case after the New York Times reported last night that Iran has issued orders for a direct strike on Israel following the assassination of Hamas leader Ismail Haniyeh in Tehran. American diplomats are working feverishly to contain an outbreak, but so far with little success. There are worries that Joe Biden may now be an exhausted and lame-duck President, whose administration is losing its grip on the region’s troubles. All the while, the drumbeat for war is rising across the Middle East.

If the situation de-escalates quickly, or if Iran’s expected response is calibrated in such a way that the two sides effectively settle into a stalemate without further open confrontation, things could get back on track. The Fed might engineer a soft landing, stock markets will continue rallying, and interest rates will continue falling. Investors have more or less locked in those bets, and are banking on an interest rate cut from the Federal Reserve in September. That has kept broader markets from getting caught up in the fear driving oil prices. Shares are still rallying and bond yields are tumbling, in anticipation of the return of easier money.

However, even without a spike in oil prices, the optimism that we’ll soon be returning to the easy money of the past looks misplaced. Unless the economy begins tanking, a mere slowdown is unlikely to move the Fed to cut too aggressively. And while Fed Chairman Jerome Powell continues to strike a dovish tone in his press conferences, as he did again after yesterday’s meeting, his optimism seems to belie the more cautious language contained in the Fed’s written statements.

However, should a sustained spike in oil prices materialise, the Fed’s task will get markedly more difficult. Markets may yet be in for an autumn reckoning.


John Rapley is an author and academic who divides his time between London, Johannesburg and Ottawa. His books include Why Empires Fall: Rome, America and the Future of the West (with Peter Heather, Penguin, 2023) and Twilight of the Money Gods: Economics as a religion (Simon & Schuster, 2017).

jarapley

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Anthony Roe
Anthony Roe
3 months ago

A lobotomised weevil could have strung out such an empty series of platitutes. On the other hand……zzzzzzzzz

UnHerd Reader
UnHerd Reader
3 months ago

Good chance the US is hyperinflating… in weimar republic the stock markets rallied first as a place to put a weakening currency. As the stock market ralies over next year or two remember this

Susan Grabston
Susan Grabston
3 months ago

Interest rate cut expectations are set to disappoint. US has been in slowdown for 8 months plus on some measures, but rerouting of oil is creating inflation. Janet Yellen may turn on short-term treasury liquidity going into US election, but the sum 9fthe parts is stagflation and increased volatility.. Extremely difficult to navigate.