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The Iran war is bad for inflation — but worse for growth
The Iran conflict is poised to inflict collateral damage on the global economy, with rising energy prices already impacting inflation and consumer costs. While inflation may spike, the article suggests a significant economic slowdown is more likely, potentially leading to deflation and necessitating a cautious approach from central banks.
Even if the Iran conflict ends fairly soon, the world economy will suffer collateral damage. Energy-price increases may be the most visible effect, but how long they remain elevated will determine the extent of damage to supply chains — and how heavy the hit will be to global growth.
Consumer and business costs are already rising as crude shuttles either side of $100 per barrel; that's evident in German annual inflation coming in at 2.8% for March, the highest level for more than a year as energy prices climbed by 7.2%. More intractable problems like unemployment and falling investment take longer to filter through — but they’re coming.Increasing consumer goods and service prices have a marked initial effect on consumer confidence. This may lead to demands for higher wages — so-called second-round effects that can spill into expectations for inflation to become elevated. But to become embedded, these aftershocks require a strong economy and tight labor markets, the conditions that fueled uncontrollable price rises after Russia's invasion of Ukraine in February 2022. This time around, the economic outlook was much weaker even before the war started. The longer-term risks to growth should offset inflation concerns.
Bloomberg
Several major bond fund managers, including JPMorgan Chase & Co. and Columbia Threadneedle Investments, reckon that higher bond yields this month are misjudging the risks of a slow down, according to Bloomberg News. “What tends to begin as an inflation shock can quickly migrate into a growth shock, and we are on the cusp of seeing a significant weakening in the economy,” Daniel Ivascyn, the chief investment officer of Pacific Investment Management Co., told Bloomberg. Demand destruction is the typical outcome of higher energy prices. This is already underway in the oil market, as my colleague Javier Blas has highlighted.
Pimco and Goldman Sachs Group Inc. analysts now peg the likelihood of a US recession over the coming year at 30% or higher. Even if the conflict ends soon, downgrades to gross domestic product across the world are set to come through thick and fast.
The is the latest to warn of a “global, yet asymmetric” shock to growth ahead of its spring outlook in mid-April, when the collective central bank and finance minister hive mind meets in Washington. The Organization for Economic Cooperation and Development's March interim report made sharp cuts to growth forecasts for several countries. It also warned that US consumer price gains could reach 4.2% this year; admittedly that's going to take strong central banking stomachs to look through.
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The fog of war makes sifting through economic data to determine the real signals even more complicated. For policymakers, overreacting to rising prices creates the double jeopardy of potentially having to swiftly reverse course; turning an energy shock into a recession would be calamitous.
If the global economy experiences an extended downturn that causes recessions in more vulnerable countries, deflation may become the more pressing problem. UBS AG analysts warn that, just as the chances of tighter monetary policy have risen, so has the likelihood that a succession of interest rate cuts might follow. In other words, a kneejerk reaction to raise rates to ward off inflation increases the potential of a policy mistake.
Federal Reserve Chair Jerome Powell delivered a timely address on Monday at Harvard University to calm markets. He emphasized inflation expectations are well anchored, that US interest-rate policy is in the right place — and, pointedly, argued that the Fed's tools have no meaningful effect on supply shocks.
The Fed and other central banks may feel forced to raise rates if second-round effects really do become evident - but until then it's arguably more prudent to watch and wait. Isabel Schnabel, a European Central Bank executive council member and prominent hawk, also has urged against overreacting. Note that the five-year forward US inflation swap rate has been falling since the Iran conflict began.
Bloomberg
Bank of England policymaker Alan Taylor, at a roundtable last week, highlighted a 1997 paper co-authored by former Fed Chair Ben Bernanke: Systematic monetary policy and the effects of oil price shocks. The paper argued much of the economic damage typically attributed to energy price shocks actually comes from the tightening of monetary policy in response — not from oil price increases themselves.
The March non-farm payrolls release on Friday, just before the Easter break, is going to be an important barometer. What currently looks to be all about inflation may soon morph into whether the global economy stays in growth mode. The outlook has clearly been damaged over the past month; but how badly will take time to determine. Central banks have been whipsawed by economic shocks ever since the pandemic; patience now may be their most virtuous route rather than letting the ghosts of 2022 spook them into raising rates in a kneejerk reaction to rising prices.
Inflation will undoubtedly pick up in the coming months, but it could burn out quickly, leaving a weakened economy in its wake. Sometimes during crises, until things become clear, doing nothing is the best course of action.
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Source: EconomicTimes
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