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Geopolitics were always going to be a risk factor this year and the deepening hostilities in the Middle East underline this. Thousands of people have been killed and there will be long-lasting effects. Tanker traffic through the critical Strait of Hormuz has ground to a halt and the crisis has already pushed oil prices over $100 per barrel, albeit briefly after President Trump signalled the conflict may end sooner rather than later. Energy prices are now going to be the key determinant of inflation this year. These tensions are likely to shape price movements over the coming days, if not weeks.
Does the Iran conflict change Ireland’s inflation outlook?
The primary way events in Iran will impact the Irish economy is through higher energy prices. Ireland imports almost 80% of its energy from abroad, which makes it particularly exposed to rising wholesale prices.
The immediate effect will come from the $25p/b rise in oil prices. A rough rule of thumb is that a 10% rise in oil prices add around 0.2ppts to inflation as pump prices and the cost of home heating oil’s start to rise and then a little more as higher transport costs make their way through supply chains. Hence, the 33% rise in oil prices will likely boost inflation by a little over 0.5ppts.
For Ireland though, the bigger impact would come from higher natural gas prices, especially as gas still sets the price for electricity most of the time. Wholesale costs make up between a third and a half of household bills. We saw the impact soaring natural gas prices can have when Russia invaded Ukraine.
If natural gas prices, and crucially futures, stay where there are, then the peak impact on inflation is likely to be around 0.5ppts-1.0ppts. However, this impact would take time to feed through when compared to the speed higher oil prices show up in fuel costs as increases in wholesale prices will take time to filter into regulated household utility bills. For example, in 2022 wholesale gas prices peaked at around 650% y/y in March 2022, but were relatively close to that level from July 2021, but electricity and gas inflation didn’t peak until October 2022. It means any peak is unlikely to be seen until the back end of this year. What’s more, if prices are sustained, the peak impact on inflation to some extent depends on when the CRU approves increases in bills, if large increases come through all at once the peak impact on inflation will be higher than if these are approved gradually over a period of months.
In any case, uncertainty is high and thus market pricing is volatile. If natural gas prices rise further because supplies of liquified natural gas (LNG) are disrupted or a protracted conflict seems likely, then we could see gas and electricity prices rise even higher which means inflation heading towards 5.0% is not off the cards.
Ireland has more room to cope than other European neighbours
Higher inflation would drag on real household incomes and therefore consumption, which has helped to underpin strong domestic demand in recent years. What’s more, around a third of Ireland’s economy is manufacturing. While that’s exacerbated by the activity of multinationals, the sector is far more energy intensive than most, making it susceptible to higher energy prices.
That said, Ireland’s recent economic strength means it has more tools to support households and firms against an energy price shock. The household savings ratio is 14.8%, which will help offset weaker income growth and ensure that consumption doesn’t fall by as much as it otherwise would.
Meanwhile, the government’s debt-to-GDP ratio is just 32.8%, so it has plenty of room to reinstate energy credits, even if Minister for Public Expenditure, Infrastructure, Public Service Reform and Digitalisation, Jack Chambers, appears to have ruled them out for now. This is one key advantage Ireland has over the rest of Europe, which doesn’t have as much fiscal space to support households and firms were a 2022-style energy shock to materialise.
What’s more, the ECB is also in a better position than the Bank of England. Inflation expectations remain well-anchored in the eurozone, which should allow the ECB to ‘look-through’ more of any energy price shock than in the UK. That means the ECB should be able to maintain its policy stance without worsening the downside effects on growth from an energy shock.
Admittedly, energy prices are particularly important to households’ inflation expectations. In many countries, memories of the Russia-Ukraine crisis are still fresh, so the ECB will be alert to the upside risks from any rise in energy prices. We had previously thought risks were skewed to further easing, but risks are now skewed towards a hike.
The bottom line is that surging energy prices risk boosting headline inflation relative to previous expectations. But, short shocks imply temporary inflation blips and limited policy moves. However, prolonged disruption may lead to material upward pressure on inflation, which would complicate the outlook for the ECB.
