The epic blunder of fighting the last war
The Middle East conflict is not Venezuela, or Russia’s invasion of Ukraine, or COVID. Policymakers should not use “the last war” as a template for the current one.
- The Middle East conflict and the resulting fuel crisis are not the same as previous crises and should not require COVID-style policy responses such as work-from-home mandates. Governments and other decision-makers need to avoid the temptation to “fight the last war”. Nor should they fall into the trap of “we must do something, and this is something”, when that something is ill-suited to the current problem.
- The focus should instead be on the key issue for the world economy: how the conflict maps into energy-supply disruption via the closure of the Strait of Hormuz and/or damage to oil and gas infrastructure in other Gulf states. Time is almost up on our initial assumption that the Strait would be closed for about a month, so we will shortly update our baseline forecast to reflect this. But the Strait is a time-limited source of leverage for Iran. At some point, third-party countries will respond to the damage being done to them; already some tankers are being allowed through.
- This is a significant shock to the economy and a challenging situation for public policy. For the next few weeks, though, the appropriate monetary policy response is “wait and see”. The current crisis is not (yet) a financial crisis or a pandemic requiring immediate, potentially out-of-cycle, action. And conditions could be quite different in a month’s time. Domestic conditions will continue to shape the RBA’s decisions at its regular meetings.
“Fighting the last war” is a common cognitive trap: trying to make a current crisis fit a past one. We saw attempts to make COVID fit the GFC template by expecting borrower distress despite massive fiscal support and, in some quarters, to make the AI boom fit the COVID template of sudden mass job losses, at least in the US.
The current conflict in the Middle East is producing plenty of examples of this behaviour, again misguided. The US/Israel attack has not gone the same way as the US intervention in Venezuela, nor are the implications like those of Russia’s invasion of Ukraine. The geographic pinch-point of the Strait of Hormuz shapes both the energy-price implications and the military ones. The context also differs significantly: the world is not emerging from a pandemic, with macroeconomic policy highly expansionary and other supply chains already disrupted.
The domestic context in Australia also differs in important ways, particularly the ceiling on east coast wholesale gas prices introduced after the 2022 episode. We are also four years further along with solar and battery installation. These changes mean that, for Australia, this is mostly an issue of fuel prices and availability, rather than electricity (as in 2022–23).
In addition, the current conflict bears little resemblance to the COVID pandemic, so policy responses should differ. We were surprised that work-from-home mandates have been seriously proposed. A fuel shortage is not a respiratory virus, and there is no reason to prevent or discourage workers from attending their workplace if they commute by foot, bicycle or public transport. Better responses would be to expand public transport coverage and frequency, encourage carpooling (including more extensive transit lanes), and cancel non-essential government travel. Only if those policies fail, or fuel shortages become so extreme that critical workers need to be prioritised, would WFH become an appropriate response.
Likewise, businesses are not facing a sudden loss of income as the community goes into lockdown. Income support measures should therefore be much more targeted, if they are needed at all.
The main similarity to the pandemic is stockpiling, as people fear downstream supply disruptions. Policy responses to address this make more sense than mandating work-from-home. Options include publicising the restocking of petrol stations that had run out of some fuels, as well as measures already taken such as temporary changes to fuel standards and the oil-for-gas supply deal with Singapore.
A kinetic war between US/Israel and Iran could drag on without necessarily having its current dramatic impact on global energy markets. For the rest of the world, the key issues are closure of the Strait of Hormuz and actual or threatened damage to gas and other civilian infrastructure in non-combatant Gulf states. But closure of the Strait is a time-limited source of leverage for Iran. At some point, third-party countries will respond to the damage being done to them; already some tankers are being allowed through.
The immediate issue for the global and Australian economies is fuel availability. Higher prices will curb demand, but periods of localised unavailability will be especially disruptive.
The implications for macroeconomic policy depend on the broader effects on inflation and growth. The RBA was already hiking rates ahead of the outbreak of the conflict. Demand growth had picked up a little more sharply than they, or we, had expected. And with the economy no longer running with significant spare capacity as in the 2010s, even small upside demand or downside supply shocks show up in prices rather than being absorbed. More frequent policy adjustments should therefore be expected.
As highlighted by the RBA’s counterparts at the RBNZ, policymakers should ordinarily try to look through the first-round, fuel-specific impacts on inflation from a shock like this. Second-round effects such as higher transport and materials costs flowing through to other prices may, however, require a response. A lift in inflation expectations is also a watch point. But if the supply-disruption element of the conflict fades over the next month or so, these effects will also be short-lived. While the forthcoming update to our baseline forecast is more severe than this, the risks around it are two-sided. It will therefore pay to wait to see which scenario plays out ahead of the May meeting. A May rate hike is still on the cards for pre-existing domestic reasons, but pre-judging the second-round effects on inflation, and the need for any hikes beyond the next one, is a much less secure strategy.
In particular, we do not expect an out-of-cycle RBA decision. These are rare: the last one was in March 2020, just ahead of lockdown, and the one before that was in 1997, both to cut rates. Even during the GFC, there were no out-of-cycle policy decisions. The decision tree facing the RBA also does not require one. May seems a long way away, but by then either things will have de-escalated, or the war will have escalated, drawn in Gulf states and worsened energy supply. De-escalation would see some of the inflationary shock soon moderate, weakening the case for further policy tightening. Escalation would be an even larger negative shock to global growth than we are already facing, but also inflationary. With the Board already split on the need to hike expeditiously, we see neither the need, nor the appetite, to bring forward that decision in either scenario. This is not COVID, and we do not expect policymakers to act like it is.
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