Middle East conflict presents two-sided risks for the RBNZ
While the lift in oil prices has raised concerns about inflation and the risk of monetary policy tightening in many countries, we view the risks facing the RBNZ as two-sided given the economy's weak starting point.
New hostilities in the Middle East, which have led to a sharp increase in the prices of crude oil and petroleum, have caused markets to worry about the potential for a protracted lift in inflation and tighter policy from the world’s inflation-targeting central banks. We think that such an outcome is less likely in New Zealand, where a starting point of spare capacity means less risk of second-round effects from a temporary rise in petrol prices. Indeed, given that starting point
, it would be folly to entirely rule out scenarios that could lead to further policy easing. This might occur if the conflict led to a severe downward revision to the outlook for global growth and commodity prices, dampening New Zealand’s fledging recovery and posing downside risks to the medium-term inflation outlook. In the meantime, faced with two-sided uncertainty, we think that the RBNZ will become even more wedded to the “on hold” stance communicated at last month’s meeting.
The main driver of domestic and international financial markets over the past week has been the attack on Iran by the US and Israel, and Iran’s retaliation targeting both Israel and US interests across multiple other nations in the region. The most enduring market impact to date has been on the price of crude oil and other key energy products. For example, at the time of writing, Brent crude has increased by $13/bbl to $85/bbl. This increase is on top of the rise seen through January and February as market participants began to anticipate this conflict. The increase in the price of refined petroleum has been even larger, with refiners’ margins also widening as usually happens when crises trigger worries about refinery capacity.
Elsewhere, safe-haven flows back to the US dollar have seen the risk-sensitive NZ dollar fall about 2% to just below 0.5900, compounding the local currency impact of higher US dollar energy prices. Global equity prices are slightly lower and term interest rates slightly higher – the latter reflecting concerns about the potential impact of higher oil prices on inflation and central bank policy.
As discussed earlier this week in a joint report with our Australian colleagues, the economic impact on New Zealand will depend on the duration of the military conflict, and the associated disruption and damage caused to international supply chains. If the conflict is resolved relatively quickly – say within the next month or so – with little damage to energy infrastructure, the economic implications for New Zealand and elsewhere could be negligible. However, a protracted conflict, especially one resulting in significant disruptions to oil supply and/or significant negative impacts on financial asset prices, could have more material downside impacts on New Zealand and its major trading partners. This would be especially so if the stresses created by the conflict were to expose other perceived economic and financial vulnerabilities across the global economy (e.g. risks associated with private credit, AI investment and associated asset valuations or China’s domestic economy).
In terms of direct exposure to the Middle East region, New Zealand has little trade with Iran. However, New Zealand’s exports to the Middle East have grown to exceed $3bn in the past year – the majority being dairy products sent to Saudi Arabia and the United Arab Emirates. Ongoing conflict would create logistical difficulties for exporters attempting to get product to the region and would increase the cost of doing business. There will also be an impact on traded services. The closure of airspace in the Middle East is impacting the movement of people as well as goods. Inbound tourism would be negatively impacted if important gateway airports to New Zealand, such as Dubai and Doha, were to remain largely closed for an extended period. Some people may be reluctant to travel through the region for a period even once the current conflict ends.
Direct imports from the Middle East region amounted to just over $1bn over the past year, led by imports of fertiliser. Since the closure of the Marsden Point refinery, New Zealand’s supply of petroleum products is mostly sourced from refineries in South Korea and Singapore. However, those refineries rely significantly on crude oil sourced from the Middle East and transported through the Strait of Hormuz. In the event of a prolonged conflict that cuts crude supply to refineries, this leaves New Zealand exposed to potential supply disruptions as well as higher prices. Our onshore inventory of refined petroleum products is very low in absolute terms and relative to global peers. The issues could move beyond a simple question of costs towards that of physical availability and the need to prioritise use. Such disruptions would raise the economic cost to New Zealand.
As a rough guide, a $USD10 increase in the price of oil adds around 11c/litre to domestic pump prices (assuming no change in the NZ dollar). If that sort of move in oil prices was sustained, it would directly and quickly add 0.1 to 0.2ppts to the CPI. However, the large increase in refining margins means the inflationary impact of the recent rise in oil prices could be significantly larger. At current levels, the combined impact of higher oil prices and refining margins could see pump prices for 91 unleaded rising to around $2.85/ltr. If sustained, that would directly add around 0.5ppts to annual inflation this year.
Moreover, a sustained oil price rise would likely pass through to local transport and other costs, leading to an additional CPI impact over time. Such increases tend to be around 30% of the direct impact of higher fuel prices, so could add a further 0.1 to 0.2ppts to annual inflation (those such effects take longer to manifest than changes in oil prices).
The impact of those increases in fuel and transportation costs could compounded by disruptions to global supply chains, which could impact the availability of some productive inputs or consumer goods, both here and in other regions. Such disruptions would further add to domestic cost pressures. However, the impact on consumer prices would also depend on the strength of domestic demand. In sectors where demand is already soft, increases in costs could result in pressure on firms’ margins, rather than significant increases in output prices.
Provided there was no significant damage to energy infrastructure, most of the above effects would unwind once the conflict was resolved and oil prices returned to pre-conflict levels. But should there be damage and/or ongoing instability in the region even after the current conflict ends, oil prices could remain elevated for an extended period. Supply chain impacts could also be prolonged depending on the nature of the damage caused during the period of kinetic fighting and the impact on risk preferences of insurers for example.
So, what does this mean for the RBNZ? In many respects it is too soon to tell given uncertainty about the likely duration of the conflict and what damage and disruption might be caused, especially to key energy infrastructure. But the RBNZ’s standard approach is to look through a near-term lift in inflation caused by higher oil prices, where that lift reflects a supply shock (due to geopolitical events or other temporary disruptions). In part this is due to the accompanying downside risks for growth, which could pose downside risks to inflation beyond the near-term (higher domestic petrol prices will reduce household disposable incomes, depressing demand elsewhere in the economy). It also reflects the expectation that any monetary policy response to a temporary inflation shock would only impact the economy after the shock had already passed, thus serving to amplify the cycle in inflation.
That said, the RBNZ will be mindful of the risk of a further uplift in inflation expectations should inflation remain in the upper part the RBNZ’s target band for an extended period, especially with the post-Covid surge in inflation still front of mind for many households and businesses. Given the current level of spare capacity in the New Zealand economy, we think there is less risk of a meaningful lift in inflation expectations than would otherwise be the case. However, the risk is not negligible. For this reason, the RBNZ will also likely be reluctant to ease policy further even if the outlook for the economy were to weaken materially.
But it would be folly to entirely rule out the possibility of further policy easing if the impact on the global economic outlook and export commodity prices was to prove severe. In the past, the more serious episodes of Middle East tensions have sometimes led to large falls in business confidence and output. While we are not expecting that this time, those downside risks can’t be ruled out.
In the near term, faced with such two-sided uncertainty, we think that the RBNZ will likely become even more wedded to the “on hold” stance that it communicated at last month’s meeting. As the conflict plays out, the RBNZ will assess how this is impacting the economic outlook and the medium-term path of inflation. Fortunately for the RBNZ, it will not have to publish updated forecasts until the next Monetary Policy Statement in late May. However, RBNZ Governor Breman is scheduled to give an address to a Business NZ CEO Forum on 24 March, touching on the current economic outlook. This might provide some insight into the RBNZ’s early thinking. We expect the RBNZ to communicate a more dovish message compared to current market pricing, which this week has been leaning towards a greater chance of the OCR being hiked sooner than December.
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