Economic and financial consequences of a deteriorating situation in the Middle East
Indicators of economic uncertainty and geopolitical risk have surged again this month with renewed tensions in the Middle East. Philippe Trainar explains why a new shock to oil prices would not be without consequences, particularly on interest rates and public finances
The consequences of tensions in the Middle East for developed economies are difficult to estimate. One thing is fairly certain, and that is that the prospects for Saudi Arabia’s better strategic protection from Iran seem to be receding as Lebanon appears more than ever at the heart of the rivalry between Israel and Iran.
Politically, this destabilization of the Middle East risks affecting the security of the Mediterranean, the Suez Canal and the Persian Gulf, and provoking a new wave of terrorism in Europe. On the economic front, all these tensions are coagulated at the level of oil prices, which could soar due to financial speculation, a drop in Saudi production or a more or less explicit blockade of the Strait of Hormuz. In terms of risk management, and even if recent developments tend to point in the opposite direction, it is therefore wise to ask what the consequences of a surge in oil prices could be in the coming weeks, and to prepare for them.
Potential consequences of a sharp rise in the price of oil
In order to determine the order of magnitude of the potential consequences of a sharp rise in the price of oil, we can simulate, using an international macroeconomic model such as the NIGEM model, from the National Institute for Economic and Social Research, a sustained global shock of $30 on the price of a barrel of oil from the fourth quarter of 2023 (compared to a current price of around $80), This shock would lead to another shock of similar magnitude on gas, and less on coal (around $3 per tonne of coal).
This simulation shows that the consequences of the shock are not immediately felt. They even take several quarters to make themselves fully felt. Typically, these consequences are greatest for inflation and activity in the third quarter of 2024. They are not fully felt on government deficits until later, around mid-2025, due to the time needed to adopt budgetary decisions. On the other hand, they are felt much more quickly on central bank interest rates, as early as the first quarter of 2024 if we assume credible central banks.
Inflation until 2026
The acceleration of inflation is relatively homogeneous from one country to another, of the order of 2 points at its maximum, in the third quarter of 2024 and it is only very gradually absorbed and will only disappear between the end of 2025 and the beginning of 2026. The resulting slowdown in activity is, on the other hand, much less homogeneous, with the GDP growth rate losing at its maximum point, in the third quarter of 2024, between 1 point in the United States, which is a flexible economy, and 1/2 point within the Eurozone, which is a less flexible economy (0.8 point in France). It is gradually being absorbed and will disappear in the first half of 2026.
The widening of public deficits, measured as a percentage of GDP, is also very heterogeneous at its maximum, reflecting the heterogeneity of the situations and constraints weighing on public finances in the different areas. It varies from 0.3 points of GDP for the euro zone, accustomed to not very countercyclical public finances, to 1.2 points of GDP in the United Kingdom, and 0.5 points for France and the United States. Regardless of the country, the widening of public deficits tends to persist over the long term, fuelling the dynamics of public debt at the global level and thus further weakening the global economy.
As for monetary policy interest rates, they react as the result of these different developments. They start to fly away in the months following the shock. The increase reaches a maximum of 1.2 percentage points of GDP in the euro area and 1.5 percentage points of GDP in the United States from the first quarter of 2024. It then only disappears very gradually, and at the beginning of 2026 it is still around 1/2 point of GDP.
A major economic and financial shock
Far from being a trivial event, a $30 increase in the price of oil, which remains a reasonable increase, still constitutes, today, after several years of reduction in the elasticity of our economies to the price of oil, a major economic and financial shock whose consequences on inflation, activity, public finances and interest rates are far from negligible. All the more so as they tend to persist for many months, in the order of nearly 24 months for inflation and 30 months for activity, or even long years, for public finances and interest rates.
Investors and policymakers who are currently looking to hedge against the possibility of such a shock are therefore right. From this point of view, there is reason to fear that the markets are currently too optimistic and that they are hardly hedged against the hypothesis of a slippage of tensions in the Middle East that would lead to a sustained surge in oil prices.