The crisis in the Middle East looks like it might be spiralling out of control. The Red Sea and the Suez Canal are now largely blocked to container ships after Houthi rebels have been targeting ships. Suez traffic is reportedly down 28 per cent in the past 10 days, and the rates for shipping containers has risen 173 per cent. With tensions rising after Israeli strikes in Lebanon and in Iran after a blast next to the grave of General Qassem Soleimani, the recent attacks on shipping might be just the beginning.
When economics students take classes on inflation, they are typically taught about interest rates and the money supply. The basic insight is some variation on the theme of “inflation is caused by too much money chasing too few goods”. What they are typically not told is that most inflations we have seen in the West have been a result of war and geopolitical conflict.
While people will endlessly debate the reaction of central banks to the recent bout of inflation, the reality is that they only had a secondary impact. The main drivers were, first, the supply chain disruptions caused by the lockdowns and, second, the disruptions of energy and fertiliser markets associated with the war in the Ukraine and the sanction on Russia.
Likewise, the previous major bout of inflation in the 1970s was triggered by an OPEC oil embargo in response to Western countries backing Israel in the 1973 Yom Kippur war. How inflation hits an economy and how long it sticks around certainly depend on the fragility of the economy and the robustness of the central bank response, however.
Between 1970 and 1985, the average rate of inflation was 11.3 per cent in Britain and 7 per cent in the United States. In 1990, the rate of inflation in Britain was still hovering around 8 per cent while the American rate had fallen to 5.4 per cent. These numbers show clearly that Britain was the structurally weaker economy and that the shock of the 1973 oil crisis and subsequent events was more harshly felt.
What this tells us is that by far the most important factor when trying to understand inflationary risks is geopolitical instability. After three years of turmoil, many of us may hope that the worst of it is behind us. But recent events in the Middle East suggest that this is not the case. Even the recent blockages of container ship transit may be enough to trigger another round of inflation, while a broader conflict could be devastating.
Consider oil production. In September 2023, the top ten oil producers in the world were pumping out around 57.225 million barrels per day. Five of the top ten countries were in the Middle East. Between them Saudi Arabia, Iraq, UAE, Iran, and Kuwait produce around 22.38 million barrels per day, or 39 per cent of total top ten production. A disruption to this production could be devastating to the global oil market.
The Strait of Hormuz, which grants entry into the Persian Gulf, is the world’s most important oil transit chokepoint. In 2022, its oil flow averaged 22 million barrels per day which makes up around 21 per cent of global consumption. Around 10.8 billion cubic feet of liquefied natural gas also transit through the Strait.
In the event of a regional war in the Middle East, it seems highly likely that the Strait of Hormuz would be impacted. In a worst-case scenario, Iran might move to shut it down. Until only a few weeks ago the conventional wisdom was that the boundless powers of the United States Navy could easily unplug these chokepoints in a crisis scenario. But we now know that even relatively small groups like the Houthis can impose naval blockades when given access to the correct technology. Iran has the largest ballistic and cruise missile arsenal in the Middle East, with much of it hidden from air strikes in hardened underground bunkers.
Then there is the question as to whether Western economies can take another round of inflation. The last bout of inflation pushed many Western economies to their absolute limit. Indeed, it seems likely that its full effects have not been felt yet and will only emerge out of the swamp in the next recession.
Interest rate increases are the most obvious macroeconomic pain point. The last round of hikes has done enormous damage to the global commercial property market, which was already reeling from the impact of work-from-home policies. According to Nationwide in Britain, house prices have been falling since February 2023. As of December 2023, they are down nearly 6 per cent from their peak. Another round of interest rate hikes would almost certainly kill the housing market stone dead.
Then there is the consumer. The recent cost of living crisis that most British people have experienced has been punishing. Four in ten people are still struggling to pay energy bills, despite prices having eased from their peak. Real wages fell by around 2.3 per cent in 2022 and 0.4 per cent in 2023. If inflation reverses and interest rates rise, the risk of a painful inflationary recession is very real.
Finally, there is the Conservative Party. The economy remains the most important issue facing the country in polls, but its importance has fallen since late-2022 when the cost of living crisis was at its peak. Yet the Tories have never really recovered from this last crisis. If inflation ticks up it could finish off the party, and those MPs who are currently hanging on to their seat by their fingernails should start questioning the wisdom of party leadership in deferring an election until later this year.
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