Iran Conflict: Global Economy Faces Inflation Shock & Slower Growth

The US-Israel attack on Iran has injected a fresh dose of volatility into a global economy that was tentatively finding its footing. While the immediate impact is being partially offset by pledges to protect crucial shipping lanes like the Strait of Hormuz, the potential for a prolonged conflict is raising serious concerns about a new inflation shock and a derailment of the expected economic recovery. The situation is particularly precarious given existing pressures from ballooning AI stock valuations and ongoing US import tariffs.

Oil Prices and the Inflationary Ripple

The most immediate concern centers on oil prices. Roughly 20% of global oil supply transits the Strait of Hormuz, making it a critical chokepoint. Bloomberg Economics estimates that a 1% drop in supply could push oil prices up by approximately 4%. A sustained closure of the strait, even for a few months, could realistically raise prices by 80% from pre-war levels, reaching around $108 a barrel. This surge in energy costs is already being felt at the pump, with US gasoline prices jumping an average of 15 cents a gallon since last Saturday, according to GasBuddy.

The International Monetary Fund (IMF) managing director, Kristalina Georgieva, warned that a 10% increase in energy prices sustained for a year could increase global inflation by 40 basis points and unhurried global economic growth by 0.1-0.2%. While Georgieva noted the world economy has shown “remarkable resilience” with growth at 3.3%, this resilience is being tested. In the UK, Oxford Economics projects that inflation at the finish of the year could be 0.5 to 0.6 percentage points higher than previously expected, building on a January rate of 3%. The Eurozone is facing a similar outlook, with potential inflation increases.

Uneven Impact Across Economies

The economic fallout won’t be evenly distributed. The US, benefiting from increased profits for its fracking companies, is expected to notice limited impact on overall growth, with forecasts remaining at 2.2% for the year. However, US consumers are already experiencing pain, with a 17% rise in Brent crude prices translating to higher fuel costs. This comes at a politically sensitive time, as anger over the cost of living contributed to Joe Biden’s defeat and now threatens to undermine Donald Trump’s efforts to project control over the situation.

The UK and Europe are expected to suffer more significantly. The National Institute of Economic and Social Research projects that economic growth in the UK and Eurozone could decline by 0.2% if the conflict persists. For the UK, this would reduce the estimated growth rate from 1.1% to 0.9%. Diesel prices in the UK have already risen to 147p a litre – the highest since August 2024 – and petrol has increased to 136p on average, according to the RAC. This adds further strain to households already grappling with high living costs, a key issue in upcoming elections.

Geopolitical Realignments and Long-Term Risks

Beyond the immediate economic impact, the conflict is raising concerns about broader geopolitical realignments. Lord Jim O’Neill, former chief economist of Goldman Sachs Asset Management, argues that the White House may have underestimated the geopolitical consequences of its actions, including the assassination of Ayatollah Ali Khamenei. He suggests that Gulf states may begin to view the US as an unreliable partner and gravitate towards China, India, and Brazil. O’Neill, who popularized the BRICS concept (Brazil, Russia, India, China, and South Africa), notes that the grouping has expanded to include Iran and Saudi Arabia, signaling a shift in global power dynamics.

Recent retaliatory strikes by Iran targeting Kuwait, Dubai, Saudi Arabia, and Azerbaijan further exacerbate these concerns. The targeting of critical infrastructure – airports, oil refineries, and gas plants – could trigger a wider reordering of global strategic alliances. A particularly alarming scenario involves potential attacks on desalination plants, which supply fresh water to the region, potentially leading to social unrest. Azerbaijan has already accused Iran of a drone attack on its airport, highlighting the escalating tensions.

The Interest Rate Dilemma

Central banks face a complex dilemma. Alan Taylor, a Bank of England ratesetter, argued that raising interest rates to combat an imported energy price shock would be counterproductive. He believes that high borrowing costs would worsen the situation, hindering investment and increasing unemployment. This stance contrasts with the approach taken after Russia’s invasion of Ukraine, where central banks were criticized for reacting too slowly to rising energy and food costs.

However, Michael Saunders, senior economic advisor at Oxford Economics and a former central bank official, anticipates the Bank of England will hold rates steady at 3.75% at its next meeting, monitoring the conflict’s development before taking further action. Financial markets currently assign a 97% probability to the Fed holding rates steady later this month. UK mortgage lenders have already begun increasing interest rates on home loans, adding to the financial burden on households. HSBC and Coventry Building Society are among those increasing rates.

What to Expect in the Coming Weeks

The immediate future hinges on the duration and scope of the conflict. Donald Trump’s pledge to protect tankers navigating the Strait of Hormuz offers a degree of reassurance, but the situation remains highly fluid. Kevin Warsh, Trump’s nominee for the incoming chair of the Federal Reserve, is expected to pursue a different approach to inflation, potentially cutting interest rates even if inflation continues to rise. The ECB is also closely monitoring the situation, with policymakers warning that a prolonged conflict could push up inflation and dampen growth. The coming weeks will be critical in determining whether the global economic recovery can withstand this latest shock, or whether it will be derailed by escalating tensions in the Middle East. Further developments are being closely watched by international markets.