How the oil shock is rippling through the global economy

Even with the two-week ceasefire announcement on April 7, the energy shock triggered by the outbreak of war in the Middle East threatens another bout of inflation and demand destruction.

The Federal Reserve’s most recent Summary of Economic Projections reflected considerable uncertainty. Those projections accompanied the Federal Open Market Committee’s decision at its March meeting to maintain its policy rate within a range of 3.5% to 3.75%.

The FOMC’s decision came despite higher median expectations for economic growth and projections that inflation would remain considerably above its 2% target.

The SEP now estimates that the personal consumption expenditures index inflation rate, the Fed’s preferred measure of inflation, will increase in the fourth quarter to 2.7%, with core PCE inflation, which excludes food and energy, also increasing to 2.7%.

That outlook marks an increase from the FOMC’s estimates in December, when it forecast a range of 2.2% to 2.7% for both the top-line PCE inflation rate and the core measure.

We anticipate the top-line inflation rate will increase to between 3.5% and 4%, which will carry with it second- and third-order effects that will transmit to households over the next six months even if the conflict ends soon.

Food, fuel and utilities have formed our baseline for assessing inflation’s impact on American households since the pandemic. Those prices are either increasing now, as with the cost of fuel, or will soon, as with food and utilities. While we do not think the price of oil has spiked enough to cause a recession, its elevated level will create a drag on growth and hurt sentiment.

State of play

Households are focusing on inflation as the cost of gasoline rises at the pump.

This very visible sign of rising inflation is on top of a micro shock occurring across the global food chain due to producers’ financial exposure to nitrogen fertilizers and other petrochemical inputs that also feed into metals and technology supply chains. The result will be higher prices for many essential consumer goods.

We will experience, at a minimum, a short-term affordability shock that will restrain consumption and growth. Even if it does not trigger an end to the business cycle, it will take a toll on the economy, and will be felt in three ways.

First-order effect: Energy prices

The first-order effect of the energy crisis is the increase in energy prices. By the time oil shipments out of the Middle East were halted, U.S. households were already competing with increased electricity demand from data centers, pressure that persisted even as gasoline prices were moderating.

The rise in the price of crude oil pushed up the cost of gasoline by nearly a dollar a gallon on average, from $2.80 in January to $3.79 in mid-March.

Second-order effect: Intermediate goods

The second-order effect is the increased cost of intermediate goods, including their transportation by land, sea or air, which raises costs for businesses and household recreation.

Every product ends up on a truck at some point, and either the business owner or the customer eats the increased cost. This goes for restaurants, clothing stores, grocery stores and manufacturers that pay to ship materials to the U.S. by boat and then deliver them domestically by truck.

There are numerous examples beyond the cost of driving a car.

The cost of bunker fuel that powers ocean shipping increased by 21% from January through mid-March on a weighted average basis as measured by Bloomberg; the Singapore spot price surged by 164%.

The cost of aluminum increased by 17% this year through mid-March. And the diminished supply of helium—a byproduct of liquefied natural gas, with Qatar producing a third of the global supply—will have a knock-on effect on the production of computer chips.

Third-order effect: Food

The third-order effect is the human cost that the shortage of petroleum-based fertilizer imposes on global and local populations. Petroleum-based fertilizers release nitrogen into the soil, increasing crop yields. A shortage of petroleum will raise the cost of fertilizers, leading to possible shortfalls of food, whether it comes from Pennsylvania or Ukraine.

While food’s increased price is felt in high-income households, it is devastating for poorer communities.

And while the U.S. has over the years tried to ameliorate the effects of energy shortages, neither the restrictions imposed during the 1970s oil embargoes nor the more recent petroleum reserve releases have worked out all that well.

Measuring affordability

Although delayed by a month, February data in the consumer price index—collected before the war began—shows what households were already facing.

Outside of rents, which account for 35% of the total expense categories tracked by the CPI, daily household attention is focused on the cost of food, which accounts for 14% of the CPI, and energy, which accounts for 6%.

While the overall inflation rate stayed at 2.4% in January and February, when the cost of coffee exploded by 25% in the months after the tariffs were imposed last April and a head of romaine lettuce climbed by 22%, people took notice.

Through mid-March, it was costing households 7.6% more to cook or heat their home with natural gas and 4.4% more for electricity, with demand from data centers competing for supply.

These pricing dynamics are not lost on households.