The Economic Consequences of the Conflict Between Israel and Hamas

The humanitarian cost of conflict between Israel and Hamas makes other issues pale by comparison, and our hopes and prayers are with the victims.

Yet the wider economic ramifications will affect billions of people globally. There is a concrete risk if the situation deteriorates that Middle Eastern energy producers could physically restrict supplies to supporters of Israel and cut production to push up prices.

Fifty years ago, the Organization of the Petroleum Exporting Countries (Opec) acted thus to punish nations supporting Israel in the Yom Kippur War. A surge in global inflation and a recession followed. US GDP fell by 0.5% in 1974 and 0.2% in 1975. UK GDP fell by 2.5% in 1974 and in Japan by 1.2%. European recession hit in 1975 – German GDP contracted 0.2%, Italy’s fell 2%.

With the US strategic oil reserve now heavily depleted, upside risks for energy prices are significant. How should central banks respond to this potential upside shock to inflation and downside shock to activity?

A substantial energy shock would reduce output and boost prices. That shock could take two forms – a restriction in physical energy supply or higher energy prices. The first would constrict supply and the second would cut consumers’ real incomes and spending. The extent of any output loss would depend crucially on how central banks responded to the shock, with that influencing the recession likelihood more than the energy shock itself. The risks of a financial crisis cannot be discounted.

The importance of these transmission mechanisms varies between countries. The US is self-sufficient in energy and so would be immune to supply restrictions. Europe would be severely affected as a major energy importer and is already suffering because of cuts in Russian supply. China, pushing for a negotiated settlement, would be unaffected by supply restrictions. All energy consuming countries would, however, be affected by a surge in global prices. A stronger dollar, seen as a safe-haven currency, would push up energy prices in euros and worsen European inflation further.

The central banking policy dilemma is how to respond to a shock that simultaneously increases prices and reduces output. The Federal Reserve under Arthur Burns took the view after the 1973 oil price shock that whatever central banks did, they could not affect the increase in the price of oil. The Fed’s response then has been criticised as accommodating the price shock and allowing it to spill into general inflation.

However, the environment in 1974 was different from today. Opec had a larger share of world energy output. Commodity prices generally were buoyant and inflation strong even before Opec’s action. US producer prices in August 1973 were up 18.5% year on year, but in September 2023 they were down 3.3% year on year. US core consumer price inflation climbed from 2.5% year on year in January 1973 to 4.7% in December. This year, January saw core inflation at 5.5%, subsiding to 4.1% in September. Thus, central bank reactions can be measured, not knee-jerk.

Central banks cannot mute energy prices’ direct impact on consumer prices, so they must focus on the second-round effects. The recent experience of high and variable inflation risks an upward dislocation in underlying inflation. The widespread central bank underestimation of inflation after 2020 shows the fallibility of inflation forecasts. It is essential to revise forecasts more speedily as new information arrives.

Second-round effects from an energy price shock will vary between countries depending on the initial dynamics of core inflation, inflation expectations, labour market tightness, and the pace of wage growth. Central bank credibility is vital. There, the Fed is relatively well placed, others less so.

Labour markets are central to second-round effects. Despite some labour markets softening, they remain tight. The US ratio of unemployment to job openings is 0.66, whereas in December 2019, it was 0.87, already well below its longer-term average. The number of days lost due to strikes in the US is the highest for over two decades, so a wage response to higher prices is inevitable. US average hourly earnings rose by 4.2% year on year in September, far above the level consistent with Fed’s 2% inflation target.

Thus, any surge in prices would see wage growth pick up as workers defend their living standards, and higher wage costs would take inflation even further way from central banks’ targets. Higher interest rates therefore look unavoidable to contain inflation, increasing recession risks. Any US recession should be shorter than in 1974–75, but the European recession could be worse.

While life looks tough for central banks, it is even more challenging for fiscal authorities. Many budget deficits, for example in the US and UK, are excessive given the stage in the cycle. A recession and higher interest rates would worsen fiscal outturns, as would subsidies and higher defence spending. With debt to GDP ratios high and debt dynamics unfavourable, central banks need to beware fiscal dominance.

This article first appeared on Central Banking on 19 October 2023 and is reproduced here with their kind permission.