Oil Shock: Neither the 1970s, Nor 2022

Oil Shock: Neither the 1970s, Nor 2022

The macroeconomic consequences of the war in Iran are likely to remain manageable, according to Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, in a recent analysis.

In this column, authors comment on economic and financial topics.

We are stress testing our macro forecasts using a simple framework for oil prices, benchmarking the expected shock on the economy against the 2022 playbook. Stating the obvious, the magnitude of the shock will be a function of the duration of the conflict and the severity of energy disruptions.

In a de-escalation scenario, the macro shock will be modest, and the global economy should re-accelerate. Higher risk premia could persist for some time, but oil prices would ultimately ease towards pre-crisis levels. Headline inflation would rise in the short-term, but the hit to growth should be modest and our constructive scenario for the global economy would remain broadly unchanged.

«Oil importing countries in Asia and Europe would be the most vulnerable.»

In a risk scenario of a protracted regional conflict, we would expect oil prices to spike above USD 100 per barrel and to remain structurally higher thereafter, around 30 percent above their 2025 average. Oil importing countries in Asia and Europe would be the most vulnerable to this shock, while natural gas would also drive global energy prices higher.

The stagflationary impact would be much more severe in that scenario. We provide some estimates by region in the following sections. Initially, we would expect most central banks to hold rates steady, if not to signal a tightening bias on the back of rising inflation expectations, although ultimately the negative growth shock would likely dominate. Most countries would likely respond with more fiscal stimulus to mitigate the impact on activity, although to a lower extent than in 2022.

Not the 1970s, not 2022, But Not a Non-Event Either

The relationships between oil prices, economic output and inflation have been shifting over time, not least because the US has become more energy self-sufficient thanks to growing shale oil production. More generally, the energy intensity of the global economy has decreased substantially since the 1970s. The amount of oil needed to produce one unit of GDP has more than halved since the 1970s, according to the World Bank. As a result, any supply-driven increase in oil prices would have a much smaller impact on aggregate output than in the 1970s.

«Any increase in oil prices would have a much smaller impact on aggregate output than in the 1970s.»

As a rule of thumb, the IMF recently estimated that a 30 percent sustained increase in oil prices reduces global GDP by up to 0.5 percentage points in the following year, while boosting global inflation by about 1.2 percentage points, with large differences across countries. This shock would be broadly consistent with our adverse scenario of severe disruptions to oil production. Other transmission channels include potentially tighter financial conditions and heightened policy uncertainty.

The starting point would also be different from both the 1970s and the 2022 episodes. On the one hand, underlying inflation is still above target in the US, and the recent memory of the pandemic creates asymmetric risks for inflation expectations
that the central banks will monitor very closely. On the other hand, there are reasons to believe that the risks of second-round effects on wage growth are low in most developed economies, including in the US, where the labour market has been loosening substantially.

US: Looking through

Higher energy prices act as a drag on US growth (where the hit to household consumption outweighs any boost to energy-related capex) while pushing up inflation (primarily headline, with some pass-through to core). However, this transmission mechanism has moderated significantly over recent decades due to declining energy intensity in the economy. Higher oil prices reduce household real income, but the energy share of consumer spending has halved since the early 1980s. While higher energy prices encourage more business investment, energy capex as a share of GDP has declined sharply since its 2014 peak.

Our working assumption is that a 10 percent increase in oil prices raises headline inflation by about 0.15 percent, with core inflation increasing by 0.06 percent due to second-round effects. Effects are front-loaded for headline (as seen in the quick pass-through to gasoline prices) and more gradual for core. GDP contracts gradually, troughing at around -0.08 percent below baseline.

«The energy share of consumer spending has halved since the early 1980s.»

Separately, the Fed’s FRB/US model also shows limited GDP and inflation impact from a $10 increase in oil prices. In our view, the persistence of energy price increases, the behavior of inflation expectations, and the stickiness of second-round passthrough of price pressures to wage pressures would dictate the eventual magnitude of the macro impact.

Under our baseline scenario, the rise in oil prices and the short-lived nature of price increases likely won’t generate sustained wage pressures that would cause the Fed to turn meaningfully hawkish given the labour market is still in a low-hire low-fire state. In fact, the aforementioned FRB/US model would suggest a dovish monetary policy response to a negative oil supply shock. In the adverse scenario of a permanent 30 percent increase in oil prices, headline inflation would rise by 0.5 percent, with core rising by 0.2 percent above current forecasts. The GDP drag would amount to roughly 0.2-0.3 percent. In fact, a 30 percent increase in the energy bill would roughly cancel out the expected fiscal stimulus from increased tax savings due to the OBBBA. The Fed usually treats a negative supply shock as transitory but given elevated inflation and scars from the pandemic-era assessment of «transitory», policy rates would likely be on hold for longer. All things considered, the risks are more tilted towards a delay in our expected rate cuts in June and September, given near-term risks to inflation and limited drag to growth under robust macroeconomic performance so far.

Besides higher oil prices, a sharp market correction with tightening financial conditions would add to the drag on growth, with some estimates pointing to a 1 to 5 cents drop in consumption for every $1 decline in financial wealth. Given the large
household holdings of stocks, a 10 percent equity market correction could amount to a 0.4 percent drag to growth. A combination of negative shocks would raise downside risks to the labour market and diminish inflation concerns, and the Fed could eventually react in a dovish way in such an adverse scenario, with fiscal policy stimulus also likely before the midterms to fend off recessionary risks.

Europa: A Less Favorable Place 

While most European countries are net oil and gas importers, the impact of higher energy prices is likely to be more moderate than during the 2022 crisis. The EU’s energy supply has become more geographically diversified, with Norway being now the top oil and gas provider, followed by the US. In addition, the region’s reliance on fossil fuels has also declined. As a rule of thumb, a permanent USD 10 rise in oil prices could lift headline inflation by 0.2-0.3 pp in one year. Adding to that is the impact of the rise in gas prices. The impact on growth would be more modest. In the adverse scenario of a bigger energy shock, a recent study by the ECB suggests there would be a substantial spike in inflation and a sharp drop in output in the event of severe supply disruptions.

«The EU’s energy supply has become more geographically diversified.»

For now, we expect the European Central Bank (ECB) to remain firmly on hold, unless persistently higher energy prices lead to second-round effects on inflation. The recent spikes in oil and gas prices are unlikely to be fully reflected in the March staff projections. Given the prevailing uncertainty, President Lagarde is likely to strike a cautious tone at the March meeting, but to err on the hawkish side.

As the United Kingdom is also a net energy importer, the economic impact of an oil shock, whether temporary or permanent, would likely mirror that experienced by other European countries. However, the second-round indirect effects of such a cost shock may be somewhat mitigated by the recent increase in economic slack, as both employment and demand have weakened further over the past months. Nevertheless, the shock would still be sufficient to heighten stagflationary risks. For the Bank of England, this environment raises the risk of delaying interest rate cuts, thereby extending the current period of restrictive monetary policy when the economy is already vulnerable. Consequently, this could require deeper rate cuts once inflation eases eventually, especially if global recession risks intensify.

Switzerland: Strong Franc as an Additional Risk

In Switzerland, beyond the impact of commodity prices, the persistent strength of the Swiss franc poses significant risks to the country’s industry, which is already challenged by US tariffs and ongoing trade uncertainty. The strong franc also threatens the inflation outlook in an environment of low inflation and already weak domestic price pressures. Foreign exchange interventions are likely to be the Swiss National Bank’s first line of defence to contain any unwarranted appreciation of the Swiss franc, even in the face of pressure from the US administration. The 0.90 threshold for the EUR/CHF exchange rate is psychologically significant, but the SNB is unlikely to defend a specific exchange rate threshold, even if the franc appreciates further.

The threshold for reintroducing negative policy rates remains high; the SNB would consider this option only in a more adverse scenario, such as if the global economy nears recession and the franc continues to strengthen, necessitating further monetary policy easing. In such a scenario, the SNB would likely cut rates by more than the standard 25 basis points.

Asia: Policy Buffers

Around 40 percent of oil imports of China are through the Strait of Hormuz, and the share is around 70 percent for Japan, 70 percent for Korea, and 40 percent for India. China’s onshore crude oil inventories are estimated to cover around 100 days of net oil imports, and Japan holds oil stockpiles of around 250 days of consumption, which could help these countries weather several months of disruption, although this may not be enough in case of major disruptions.

As a rule of thumb, a 30 percent increase in oil prices could push China and Japan inflation higher by up to 0.6 percentage points. The drag on GDP growth should be more manageable, around 0.3 percentage points or lower, and we would expect the Chinese government to offset this shock through more policy easing as inflation remains subdued overall.

In Japan, the case for more fiscal stimulus would strengthen as well. Meanwhile, rising geopolitical risks would reduce the likelihood of a near-term rate hike from the Bank of Japan. For the rest of Asia, the sensitivity of inflation to a 30 percent increase in oil prices ranges between 60 bps to 120 bps, with a larger impact in countries with a higher energy weight in the CPI basket (e.g. Philippines, India, Thailand). The negative impact on growth would remain relatively manageable (though it could be large for some). Most Asian central banks are likely done with their easing cycle.

Frederik Ducrozet is Head of Macroeconomic Research at Pictet Wealth Management.