The Iran war will cause inflation to surge | The Economist

The war in Iran is set to have a huge impact on the cost of living. It's obviously already hit the oil price, but it's set to feed through to food prices to transport prices. If you're going on holiday, for instance, and pretty much everything else that takes energy as an input, which is virtually everything. And there's now a risk that inflation starts to spiral again and price rises. Get out of control. Okay. Talk me through the mechanism. How do we get from, hiccups in the oil markets to all of that? So energy is an input for pretty much everything else you buy. Houses need to be heated. Factories any good that's produced needs to be transported in. That takes petrol. People need to be paid in order to do all the things, like heat their houses and fill their shopping basket. So eventually the energy cost goes through to, to wages as well. And as all of these costs rise, the prices that businesses need to charge for goods and services rises as well. And it goes much more broadly than just the immediate things that oil feeds through to which do include other things that are inputs where it's a little more direct, right? Like, fertilizer, for example. Right, exactly. It's not even just oil that's trapped in the strait of Hormuz. Fertilizer is another big category of things that passes through that strait. And there's an obvious feed through immediately from fertilizer to food. If there's a shortage of fertilizer around the world, then you're eventually going to get food shortages. And people who are expecting that in the coming months are already going to start driving up prices. For example, natural gas is something that's trapped in the strait that's used to produce a lot of fertilizers. But there are also kind of more, there are also other fertilizers that are trapped there, such as urea or, sulfate comes through there as well. So talk to me about the mechanism where people come into it, expectations and the like. Yeah. So this is really the more dangerous thing for central bankers when they're thinking about controlling inflation. They can see that when there's a shortage of something like energy or fertilizer, that that's going to rise, raise prices in its own right. But central bankers often do what's called looking through that shock. You know, they don't control the supply of this stuff. The supply is going down that's naturally going to send prices up. But eventually that effect will dissipate. Central bankers can kind of relax about that. When we start talking about inflation expectations, though, and change the behavior. This is what causes a deeper rooted problem. If I look around the world and I see the prices not just of energy, but of pretty much everything going up, in particular, if I see the price of my shopping basket going up each week, I am going to start to think I'd better get paid more. And if I'm a member of a union, I'm going to put pressure on my union to bargain wages up. And if people start doing that across the economy, then that creates its own new pressures, because one person's wages are another person's costs. So the effect of people trying to bargain their wages up in itself causes prices to rise faster, which then causes other people to want to bargain their wages up more. This is what economists call the wage price spiral. A positive feedback loop sounds like the sort of thing that's hard to stop once it starts. Exactly the sort of thing that you really need to clamp down on before it gets out of hand. The trouble is, the central bank's tool for clamping down on that is raising interest rates, destroying demand by making money more expensive, making businesses be able to borrow less, making them less able to buy their own inputs. Making people less able to afford their mortgages, and more likely to save money so they spend less. This is all painful for pretty much everybody. You see demand going out of the economy because people cannot afford, as much, and because some people are starting to lose their jobs because when we lose demand, also typically we see unemployment go up as well. But this mechanism that connects oil shocks of various kinds to right down to consumer behavior and so on with this kind of well known right, the world is going through this kind of hiccup before. It is well known, a big example that people give, where it really got out of hand in the past is the 1970s. This is the, the original Iran oil shock that people that the central bankers in particular don't want to repeat. What's particularly dangerous at the moment is this, in a sense, is a one off shock. It's an idiosyncratic thing, war in Iran that has blocked the Strait of Hormuz. But in another sense, it's not a one off shock because we've had several of these over the past few years. We had the shock of Covid, of the pandemic and the bottlenecks that followed that we had the previous energy shock in 2022 when Russia invaded Ukraine and the oil price spiked before that. We've had the shock last year of a President Trump's tariffs, raising the costs of lots of things. All of these a kind of one off shocks in their own right. But when you hit people with shock after shock, they stop thinking of them as one offs. And that's the sort of thing that in particular can raise people's inflation expectations and make the problem have deeper roots. the basis of those more recent shocks, though, did they give us a guideline for what to expect from this one? So the IMF has rule of thumb for how oil shocks eventually feed through to global inflation. And that is, for each 10% sustained rise in the oil price

you get an additional 0. 4 percentage points on global inflation. Now, what does that mean now since the start of the Iran war, the oil price has risen by about 50%. So we're expecting global inflation by this rule to increase by about two percentage points. Now, I should say, though, that is a kind of all else being equal based on historical averages type rule of thumb. So take a pinch of salt for how precise it should be. But all things won't remain equal if central bankers get involved and try to stop that rise happening. Exactly. And central bankers now have this tug of war going on in their heads. On the one hand, they don't want to repeat the mistakes of the previous shock and shock. This was the energy shock of 2022, which, combined with labor shortages and supply bottlenecks after the pandemic, their mistake then was to react too slowly in much of the wage world. So they let inflation rise much more than they should have done, thinking, oh, this will be transitory. All of the effects will fade. So we don't need to raise interest rates and then belatedly realize this was the wrong response, started raising interest rates. And because inflation had risen so high already, they probably needed to raise interest rates further than they would have done their acted sooner. On the other hand, and I'm particularly thinking of the US here, president Trump has just appointed a new chair of the Federal Reserve, implicitly on the understanding that he is sympathetic with President Trump's wish in the US treasuries rate for interest rates to fall. And we've seen how much he can make fed officials lives difficult when they don't do what he wants to do. So if Kevin Warsh, the incoming fed chair, starts raising interest rates instead, you can kind of expect all hell to break loose. For him personally, this tug of war means it's really difficult to figure out how central bankers are actually going to deal with this shock. And to make matters worse, for them, the increased oil price is not just going to raise inflation, it's also going to hurt global growth. And that is another kind of element in the tug of war for whether they'll raise interest rates or not. Because our listenership is such a large fraction of the global population, I'm concerned that what we discuss here has only served to increase inflationary expectations. And thereby we have made market moving discussions here. Well, I suspect listeners to the intelligence that frankly, too intelligent to do that. So I wouldn't worry too much about that risk. But there's obviously a serious point here. The more we're all talking about inflation, the more likely it is that people's inflation expectations go up and therefore that becomes self-fulfilling. Yes. Sorry. I didn't mean even momentarily to underestimate our audience. You're quite right. Josh, thanks very much for your time. Thanks for having me, Jason.