Geopolitical tensions and risks to the inflation outlook

Just as inflation appeared to be getting under control in recent months, rising tensions in the Middle East have shaken this view and now represent the major risk to our economic and inflation outlooks.

The focus of this new uncertainty centers on the energy markets, which have been roiled by attacks in the Red Sea, fighting in Gaza and the war in Ukraine.

Energy, after all, has an outsize impact on American business and consumers. Although energy makes up only 7% of the U.S. consumer price index, disruptions of oil and gas supplies can cause large price distortions that affect both actual and expected inflation.

For now, inflation expectations remain well anchored in the United States, though that could change if geopolitical tensions continue to rise.

For evidence of the impact of these tensions, look no further than the Suez Canal, where the proxy war between Iran and the West is taking place.

Through the end of last year, 12% of global shipping traffic moved through the Suez Canal, and between 4% and 8% of liquefied natural gas is shipped through the canal.

Last year, roughly 8.2 million barrels of oil per day were sent through the canal. In addition,16.2 million metric tons of liquefied natural gas from the Atlantic basin and 15.7 million metric tons from the Pacific basin moved through the canal, according to S&P Global Commodity Insights.

With global shipping costs increasing by 175% since the end of November, there is little doubt that the increase will be passed along to firms and households.

Before this latest upheaval in the Middle East, there were good reasons to expect that inflation would continue to recede. The price shocks during the pandemic and afterward were fading, after all, and price levels were returning to fair values.

But the spread of war in the Middle East is likely to further disrupt trade. The consequences could be the eventual deterioration of economic activity as shortages of goods pressure inflation higher once again.

Market expectations

The market’s reaction to January’s consumer price index, which showed an inflation rate above 3%, was to push the yield on 10-year Treasury bonds back above 4.06%. This matched the forward market-based expectations of inflation in 10 years.

We suspect that market participants were reacting to increased uncertainty around monetary policy and the threat of further disruptions of trade, which are likely to pressure consumer prices higher.

The impact of diversification

The memories of surging energy costs amid rising tensions in the Middle East still linger, dating to the gas lines of the1970s.

But major economies have not stood still in the wake of these crises. Diversification within both the energy sector and the supply chain gives reason to believe that this current conflict will have less of an impact on U.S. inflation than did previous conflicts.

The U.S. consumer price index can be divided into four categories of spending, in ascending order: energy, food, shelter and all other items.

Energy: In the short run, we expect to see a subdued impact of the conflict on the energy component of the U.S. consumer price index because of diversification of that sector. In the long run, we expect more and more households to invest in energy-efficient appliances and vehicles, reducing the demand for fossil fuels.

Purchases of energy make up only 7% of total expenses for American households, with energy prices decreasing at a rate of 4.6% per year as of January 2024 after peaking in the middle of 2022.

The shift from coal and oil to natural gas and renewables in the past five years is reducing the cost of electric power generation, all to the benefit of the U.S. economy and Europe’s national security, which can now rely on U.S. supplies of natural gas.

Domestically, sales of electric-powered vehicles continue to grow, while renewables (wind, solar and hydro) have overtaken nuclear and now account for 22% of electricity generation.

In terms of price stability, the marginal cost of operating a renewable source of electricity is less susceptible to price manipulation or scarcity of supply than are traditional fossil fuel plants.

At the same time, the price of natural gas has plummeted. It now accounts for 41% of U.S. total electricity generation, overtaking all other fossil fuels burned to create electric power. And because of its domestic production and its need to be piped, domestic natural gas prices are likely to remain localized within the U.S. market, more so than fungible fossil fuels that remain subject to supply and price manipulation.

Food: Purchases of food account for 13% of total U.S. household spending, with prices increasing at a yearly rate of 2.6% in January after peaking at 11% in 2022. The impact of the Ukraine war on the availability and the price of food remains a concern for Europe and especially for developing economies. While food prices can be affected by global events, for the most part that is not the case in the U.S.

Shelter: Shelter is the most local of the major components of the CPI, and least likely to be affected by war. Shelter, however, is the biggest single ticket, totaling 36% of U.S. consumer spending.

The average cost of shelter is increasing by 6% per year as of December, with monetary policy affecting borrowing costs while local conditions affect the value of land and the availability of new rental facilities.

New rental prices have been decelerating and mortgage rates dropped a full percentage point in the past quarter, though there is no guarantee of that trend continuing.

All other goods and services: Purchases of all other items constitute 44% of total household expenses. Prices have been flat since mid-2023.

The takeaway

History suggests that war has a detrimental effect on inflation and economic growth. As we have already seen, conflict in the Middle East has a direct impact on the cost of trade, the prices of imported goods and, ultimately, economic growth.

In the short run, we expect prices of goods to be affected by increased shipping costs and insurance fees should the war continue. In the longer run, that impact should ease as supply chains are adjusted.

Because of advances in energy production, we expect the current conflict to have less of an impact on U.S. inflation than did previous crises.

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This article was written by Joe Brusuelas and originally appeared on 2024-03-05.
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