The Decisive | Season 6 Ep.4 - State of Shock: Economic Impacts of Middle East Conflict

View Full Transcript

Ken Wattret:

Hello. I’m Ken Wattret. I lead the Global Economics team at S&P Global Market Intelligence. And joining me today are the economists which lead our coverage of many of the major countries and regions. Ralf Wiegert for the Middle East and North Africa; Hanna Luchnikava-Schorsch for Asia Pacific; Diego Iscaro for Europe; and Ben Herzon for the U.S.

Since the conflict began in late February, we've made material changes to our economic forecasts consistent with a negative supply shock. We've revised up our inflation projections and revised down our growth projections. Our forecast for global real GDP growth this year, for example, has been lowered by around half a percentage point since February to 2.4%.

That would be the weakest outcome since 2009, excluding 2020’s pandemic related drop. Now, the variations in the magnitude of our national growth and inflation forecast changes, over the past couple of months, reflect important differences in national sensitivities to this shock. With regard to inflation, those differences include variations in energy weights in consumer price indexes, the fiscal space for governments to mitigate the rise in energy costs for households and businesses, variations in currency movements, and differences in demand and labor market conditions. They will typically influence the likelihood of second round effects on inflation.

Now with regard to growth, the key differences include whether a country is a net energy importer or exporter, its reliance on energy supplies from the Gulf, its energy mix, and the availability of strategic reserves, and also policy responses, not just fiscal support, but also how central banks will react to the shock. Now, Ralf, Hanna, Diego, and Ben will focus in more detail on those national differences shortly.

But beforehand I'd like to spend a little time discussing the key assumptions that are incorporated into our forecasts and how changes in any or all of those could make material differences to our assessment of the outlook. Drawing also on some historical experience of prior oil price shocks. Now, our current forecasts were updated earlier this month, and they are aligned with the base case energy assumptions generated by our colleagues in the S&P Global Energy Division.

Now, in brief, those entail flows through the Strait of Hormuz, remaining very low through April, with a gradual recovery from May. The price of dated Brent crude averaging around a hundred dollars per barrel during the second quarter of this year, and ending this year and next year at around $70 per barrel.

That implies annual average prices for this year of around 50% above where they were in our forecast prior to the conflict, and for next year, around 15% higher. Other energy price assumptions, including for gas, which are very important for some countries and regions, they've also been adjusted in line with the latest assessment from S&P Global Energy.

Now in this base case, headline inflation rates rise primarily due to the effects of higher energy prices. But we do expect some price pressures to materialize in other areas, including food prices due to broader supply disruptions. Second round effects on inflation are expected to remain broadly contained, and inflation expectations anchored with major central banks responding to the shock relatively cautiously as a consequence.

And that is expected to limit the depth and duration of the expected negative impacts on growth. Now, two alternative scenarios have been, under consideration since the conflict began. One is based around a swifter resolution to the conflict and related disruptions. And another much more adverse scenario is centered on more protracted disruptions.

Now that latter scenario termed oil shock incorporates much higher levels of energy prices than in the base case. Now, in that scenario, not only does headline inflation rise further, but we would see much broader base price pressures, also leading to less accommodative global financial conditions.

Now, that kind of scenario is not currently discounted in financial markets and the market stress and like asset price corrections that would ensue, would materially increase the likelihood of recessionary or near recessionary outcomes, particularly in the economies most vulnerable to protracted disruptions to energy supplies.

Now the probability of that adverse scenario materializing had been diminishing recently given the negotiations aimed at bringing the conflict to an end and reopening the Strait of Hormuz. But as events of the last few days have again highlighted, the situation can change rapidly and the perception of where the negotiations are from the two sides can differ markedly.

Now our colleagues in the energy division are of the view that financial market pricing is currently disconnected from the reality of the disruptions to energy production and supply that will become apparent over the coming weeks, even if the conflict ends relatively swiftly. Now with regard to central bank reactions to the change in inflation prospects, which will be a key determinant of the financial and economic outlook, a textbook response to a transitory rise in headline inflation driven by an energy supply shock would typically be to look through it.

But if higher energy prices persist and the inflationary effects spread, reflected in rising core inflation rates, then tighter monetary policy would likely follow aggravating the adverse financial and economic impacts of the shock, and a couple of historical examples help to illustrate the importance of those different reactions. In the late 2000s and early 2010s, for example, the price of dated Brent crude oil peaked at well over a hundred dollars a barrel, and headline inflation rates rose markedly, but amid generally weak demand conditions due to the global financial crisis and the subsequent crisis in Europe, core inflation rates generally remained rather low, and the major central banks looked through the elevation of headline inflation rates.

But in the early 2020s, following Russia's invasion of Ukraine, core inflation rates rose markedly, and the reaction of the major central banks was very different, albeit it took some time to materialize. Now, neither of these shocks is a perfect fit to the current circumstances. Nonetheless, the key point is that how core inflation evolves will have a major influence on the outlook. And in our current base case, we assume rather limited effects.

The more protracted the energy shock, the greater the risk of more adverse outcomes. Now if we look at major oil shocks in the past, they've invariably had material negative impacts on global economic conditions. But the magnitudes of those negative effects will depend on various factors. That includes the duration of the shock, of course, what's behind the shock, the policy responses to try and mitigate some of the effects, or in the case of higher inflation, potentially worsening those effects and the economic conditions before the shock took place.

Now, one positive issue to highlight currently is that in real terms, the rise in oil prices that we've seen since late February is much smaller than some of those in the past. The current price of dated Brent in real terms, for example, is around half of its peaks back in the late 1970s and in the late 2000s. And another source of comfort for the global economy is the reduction in the energy intensity of production, which we will return to a little later on.

The final point to highlight is that it takes some time for the adverse effects of negative supply shocks to become apparent in official economic data. Our PMI figures capture the effects relatively quickly. We already saw in March's data, for example, a marked pickup in pipeline price pressures for goods, and we also saw clear signals of a significant slowdown in global growth. We'll get April's flash PMI figures later this week. We'll also be watching the signals from other indicators, of course, along with other developments that have the capacity to move the macro needle.

And regarding the issue of lags. It will take time for the effects of higher energy costs to fully pass through to other prices, and for the effects of supply disruptions to appear. That can take several months or longer, so it'll be some time before central banks can fully gauge the inflationary implications of this shock and the need or otherwise to respond.

Let's now dig a little deeper into the different national and regional impacts of the current conflict. And we'll begin at the sharp end with Ralf and the Middle East.

 

Ralf Wiegert:

Thank you very much, Ken. And, when we look at the Middle East and the Middle East and North Africa region, and we do the forecast, we first try to categorize the countries there, in which categories they fall basically. we have large divergences.

And this is important. We have divergences between oil exporting nations, or hydrocarbon exporting nations, hydrocarbon importers. And also, we have logistics and tourism hubs, which are also important in the region. So what is, what is deferring those, when we have countries like Saudi Arabia, the UAE and Qatar Kuwait, who have really sizable reserves, sizable fiscal buffers and also foreign exchange currency pegs in place, which ensure that their economies can withstand significant shocks.

This is important. This is, also, the case right now. On the other hand, we have countries like Iraq, which do not have the sizable buffers like Saudi Arabia, like the UAE, and which where oil exports are basically trapped in the Gulf and they increasingly face external liquidity risks.

Third, we also have, on the other hand, we have, oil importing nations, like Egypt, Jordan, Morocco, Tunisia, Lebanon, and others which are really dependent on, and which face acute macro risks, from rising inflation due to higher oil prices, which induce fuel price increases, debt rollover needs and supply chain disruptions. Those, there are limited buffers and the refinancing needs of those countries really heightened their vulnerability. And there are also concerns around sovereign spreads widening and inflation upticks, which will become an issue in the next several months as inflation data is reported.

On the other hand, we do also have countries like the UAE and Qatar are also important, logistics and tourism hubs and those non-oil industries in those countries might, are suffering as well. There have been cancellations for flights, for instance, shipping traffic has been much reduced and this is impacting these nations as well.

So when we look at the non-oil economy, we usually take our PMI data and, this was actually the first data which was published following the breakout of the war in the Gulf in early April, which, basically looked at the, at the, how those economies performed.

And this is basically what the, what the survey showed U.S. So we had a pretty dramatic, fall in the headline PMI for Qatar, which fell to 38.7 points in the March print. The Saudi Arabian PMI also fell to, contraction territory, although it was still held up relatively well.

 

And, the UAE PMI fell to a, to a multi-year low, the lowest level since the COVID crisis. But it still was in expansion territory. So on the other hand, we have serious supply delivery times issues. So supply delivery time is lengthened, for Qatar and for Saudi Arabia in particular, but held up, actually still shortened for the UAE. So, we expect further deterioration in both the PMI and supply delivery times, for those economies.

What does that tell us? When we look at the growth rate? So we see Saudi Arabia, for instance, holding up relatively well that the non-oil economy there is slowing, but the oil economy and that basically tells the story of Saudi Arabia rerouting most of their oil shipments from the Gulf Coast to the Red Sea shore, through these West Pipeline.

So that actually ensure that ability to reroute those oil shipments, enable the Saudi economy to hold up oil exports almost, at level at pre-war levels. So this ensured that the, that the Saudi Arabia economy is only has been downgraded from 4.2% real GDP growth in 2026 in the pre-war forecast to 2.2%.

The UAE, however, is, their oil exports held up relatively well there as well because they have also an ability to bypass the Strait of Hormuz, but only to some extent. And the non-oil sector of the UAE economy will be hit much harder, due to tourism and all the service trade and transportation sectors.

And also the big unknown and uncertainty is the real estate sector there, which performed extremely well in the last five years, but which might actually see a significant slowdown this year. So we forecast just 0.7% growth, which is down from 5.9%, in the latest pre-war forecast.

And, when we look at Qatar, Qatar is obviously much more hit because there we had also a significant, damage to production assets, gas production assets, at ER fund. which, a basically means that gas production will be significantly below pre-war forecast for the next one or two years in Qatar.

So growth was reduced from 4.9% this year to a recession of 3.5% in the April forecast. When we look at the key effects for the oil importers, there have been also growth reductions, but the biggest impact, on the oil importing side for nations like Egypt, Morocco, and others is that it’s a price effect and the impact on consumers.

So we have a, an increase of average price inflation, from round about 2.2% in 2026 to 3.3% in the latest inflation print. This is a one-point increase, but the risks are clearly geared to the upside here. And, we might raise this inflation forecast still further if needed.

On the other hand, we have, for the GCC countries and that includes, of course Saudi Arabia, the UAE, Qatar, Bahrain, Kuwait, and Oman, we have, of course, slightly lower oil export volumes, but the value of oil exports or revenues has increased quite remarkably.

So the current account surplus for the GCC is actually increasing. So what is taken away from the oil importers is actually added on the current account of the GCC there. So we have a, the position, the external position of the GCC countries is actually improving by the conflict.

So we'll continue to watch out for any new data that's being published. And the next key item will be GDP data for Saudi Arabia on 30th of April. And shortly after that, we'll have the April print for the PMI data, for the GCC countries. I'll hand over to Hanna there to shed a little bit more light on the impact for Asia.

 

Hanna Luchnikava-Schorsch:

Thank you, Ralf. And, again, Asia Pacific region stands out as, the most exposed, or among the most exposed regions due to its high energy dependence, with effects being not only higher prices, but physical shortages. And, over several weeks of conflict, we have observed that the supply disruptions have broadened beyond just primary energy, to refined fuels, fertilizers, as well as industrial inputs.

And that changes the picture within the region also quite substantially in terms of the implications, for individual economies within the region. Where if countries that are most susceptible to crude oil shortages from the region, include South Asia, but also Philippines, Japan, we also see that natural gas dependence is very high across, some economies within South Asia, India included, as well as Southeast Asia. We see that for a number of other commodities exposures are greater for sub-regions like ASEAN where potential shortages of helium in particular, which originates in the Middle East region, could lead to production issues for, technology related, outputs, including semiconductors and feed into, issues with exports, which are a significant growth driver for these economies.

So what we have done is we have constructed a vulnerability index for the Asian economies where we have looked at a combined, affected imports, from the region, including energy imports, fertilizers, industrial products, on a net basis as a share of countries’ GDP. And we looked at the vulnerability on the macroeconomic level, including the underlying inflation pressures, including external vulnerabilities, not least because of the pressures on the currencies, as well as the fiscal buffers available to these economies.

What's important to note is that compared to the crisis triggered by the Russia, Ukraine conflict in 2022, generally speaking, Asian economies come into this shock on a stronger footing where growth, particularly during the last quarter of 2025 and the first couple of months of the current year, has been fairly resilient, supported by robust domestic demand and by strong exports particularly of semiconductors and technology-related products.

Macroeconomic fundamentals have also been stronger with inflation expectations well anchored, with currencies being relatively strong and foreign exchange buffers also being significantly above what we have seen during that 2022 crisis. But that having said, we still see that a number of economies within the region are particularly vulnerable to the shock, and this vulnerability is proportional to the length of duration for elevated energy and materials, prices in particular.

In that sense, economies like mainland China and Japan, and some other economies with large, strategic reserves as well as more diversified energy mixes and policy buffers fare relatively well. We do not expect macroeconomic stability to be disrupted for this economies. Although we will see an impact on overall output and demand, and I'll talk about it in a second.

At the same time, a number of economies, which we classify as squeezed economies, and these are mostly large economies of Southeast Asia, as well as India, where India and Philippines in particular stand out as the most vulnerable, again due to their large energy dependence. Philippines is also the country which does not provide price caps of subsidies.

So we will see enormous immediate price shock translating into domestic prices. And this is where the effects will be the largest among large Asian economies. And then there are a number of smaller economies, particularly in South Asia, including Pakistan, Sri Lanka, and Bangladesh, which will face significantly higher macro financial risks during their, already fragile balance of payments, as well as fiscal accounts and we'll talk about some of it in a moment.

But what is also important to keep in mind as we speak about the region is that the vulnerability to this shock is translated not only through the direct exposure to the Middle East, but also through the secondary exposure to supply disruptions or potential supply disruptions within the region itself.

And this is particularly true for refined products where a number of refiners within the region are being key suppliers of refined products to other Asian economies, including South Korea, as well as a number of other countries. And that is historically demonstrated by economies like Australia and New Zealand, which have very limited exposure to the Middle East directly but they do rely on supplies, for refined products on countries within the region, particularly South Korea, and Singapore. Similar story is for fertilizer supply, where a number of economies within the region also depend on supplies of fertilizers from mainland China. Mainland China has been already restricting exports of sulfur fertilizers even before the conflict began.

Nitrogen fertilizers have so far been exported, but any disruption to that supply could potentially also jeopardize a number of markets within the region, with implications being, energy security as well as food prices with the impacts on headline inflation down the road.

Now, what does it mean for our forecast? Again, consistent with some of the impacts and vulnerabilities, which have already been mentioned, we have made significant adjustments to our headline annual real GDP growth as well as CPI inflation, among other indicators. For the region as a whole, we have lowered the aggregate annual real GDP growth for 2026 by about half a percentage point between our February and April forecast, excluding China.

And for our CPI forecast, we have raised the forecast for the aggregate CPI for the region, excluding China, by about one percentage point for 2026. If we look specifically across a number of economies, the largest adjustments have been made to the economies of India and the Philippines, not surprisingly.

We now anticipate India's annual real GDP growth to fall below 6% in the fiscal year, which just started in April. So financial year 2026. This is in contrast to our earlier forecast of 6.8% for the year. Again, the impacts here would translate not only through prices, but also through physical shortages, which are likely to affect output, particularly in the current quarter, but also through a number of other linkages between India and the Middle East region, including financial capital flows as well as remittances on which India remains dependent, specifically from the Middle East.

For the Philippines, we are also expecting, real GDP growth, to reach only 4.7% during the current year, from our previous forecast of 5.7%. So it's one percentage point, revision, compared to our February forecast. And again, with inflation, we are seeing a similar story where India and the Philippines have seen the largest revisions. As economies with meaningful adjustments to CPI inflation for 2026, South Korea, Japan, and Thailand. And, that also has implications for the monetary policy within the regions. As Ken already alluded previously, it'll take time until the central banks will fully assess the impact of the shock on inflation, with some being able to look through some of this effects.

But generally speaking, we now anticipate monetary policies within the region to switch from a broad accommodation, which we expected before the conflict, to a slightly tighter monetary policy with a number of central banks expected to start raising interest rates already in the current year, including the Reserve Bank of India and the central banks of the Philippines as well.

Now I think it would be also worth spending a few moments on mainland China in particular given the region’s, and the global, reliance on this economy. And here, high energy costs and supply disruptions will affect cost-sensitive industries, considering that around 40% of imported oil and gas as well as a sizable share of petrochemicals and metals are coming from the Middle East.

But the effects, the macroeconomic effects, are likely to be mitigated by several factors. One of them being, more diversified energy mix, where China's energy supply relies on over 50% on coal. And, China's overall energy independence is at about 80% compared to some of the other countries within the region.

Beyond that, China does have large strategic reserves, petroleum reserves, which amount around 118 days of net imports, based on the 2025 data, and also policy space and policy options available to mitigate the impact on particularly domestic prices. China does have controls on crude oil prices domestically as well as implemented export caps in a number of products, including fertilizers, which I already mentioned before.

In addition to this, China's surplus supply, particularly in a number of industries, may provide it with the ability to mitigate some of the supply gaps globally, with industries, particularly petrochemicals as well as metals, being able to see higher profits and potentially help China solve its goal of reducing oversupply domestically.

Again, this is important to emphasize that it is very unlikely that, India's supply and demand imbalances will be resolved. but this is one of the mitigating factors, which we need to consider as we talk about the impact on mainland China. Now as we look at the macroeconomic impact, and our forecast, what is also important to consider, similar to some of the factors, which we already discussed for the region, that the economic momentum during the first quarter has been fairly strong. China's real GDP growth was registered at 5%, during the first quarter, compared to four and a half percent in the first quarter of 2025, with manufacturing in particular gaining pace.

And we have also seen substantial correction in nominal GDP growth, with nearly a full percentage point acceleration in growth rates compared to the previous quarter, suggesting that deflationary pressures, which we have seen in the previous several quarters are narrowing. As we talk about prices, it is very likely that rising energy costs will have an impact on producer prices with producer price index already registering a positive increase in the March outcome. Consumer prices will still be to the extent limited by weak domestic demand and government caps on the pass through domestically. But nevertheless, we do see consumer prices also rising with our inflation forecast adjusted accordingly and an expectation of consumer price inflation averaging 0.8% during the current year, and also rising further in 2027, with an evidence of a gradual reinflation, as the government continues to implement its anti-deflation measures. With that, I would like to pass my commentary to Diego to speak about the impact on Europe.

 

Diego Iscaro:

Thank you, Hanna. For Europe, the Middle East conflict is yet another negative supply shock of which we've had quite a few in recent years. And so you have to summarize our views in a very short elevator pitch. I would say that the impact on a forecast is meaningful and negative, but still smaller compared to the previous energy shock back in 2022.

Current baseline projects a slowdown in activity, but no recession yet. We’ll expect more tightening of monetary policy conditions compared to pre-conflict projections. Let's start with a brief comparison to the Ukrainian energy shock back in 2022, which I think is an interesting way to frame the scale of the risk.

Now despite a large increase in oil prices in the start of the conflict, Brent Oil when measured in euros is still around 20% below where they were back in ‘22 with the peak back in 2022. And these are nominal terms, the peak is even lower when measured in real terms. That's it. When we take inflation into account – this is not only about oil, in particular for Europe, gas is particularly important. And while European wholesale gas prices, which are key for the manufacturing sector and also key determinant of electricity prices in several countries, they have increased by almost two thirds, since early March.

They remain substantially below where they were back in2022. And finally, if you look at, the energy sensitivity of the European economy. It’s lower than four years ago, and this is due to a higher share of renewables in the energy mix, higher energy saving investment, partly due to EU wide measures.

And also due to the fact that production in several energy intensive areas, including chemicals and base materials have structurally declined since 2022, which the net effect now is that Europe needs less energy per unit of output compared to four years ago. So the initial takeaway based on baseline projections for enterprises and the development of the conflict, but this is at this stage is not a repeat of the 2022-style energy crisis yet, but it is a clear deterioration, compared to our projections two months ago, when the narrative was shifting towards a more durable, fiscally supported recovery in parts of Europe.

Now the main channel in which the European economy will be impacted is by higher energy costs, not only for households, but also for corporates and producers. So the data we have for March already show a large increase in inflation, and there's more to come. Higher petrol and diesel prices have an immediate impact on inflation, but higher wholesale gas prices tend to be reflected with a lag of around three to six months, due to factors such as regulated retail markets and contractual arrangements. And we also expect the increased inflation to become broader during the second half of the year as higher energy prices feed through to other areas of the economy, including food prices and the service sector.

Now when we look at the inflation outlook, I think the important difference between now and the situation back in 2022 is the risk of second-round effects. That is when high energy prices result in demand for high wages, and the more general increase in inflationary pressures is currently lower.

As Ken alluded to at the start of the call, back then, inflation persistence was amplified by the reopening of the economies, which drove quite significant pent-up demand, particularly for services, acute labor shortages and large fiscal support. Today, those conditions are weaker or absent, and also monetary policy is much less accommodative than it was four years ago.

Taking all these factors into account, we currently think that inflation is likely to peak at just about 3.5% in the second quarter of the year, with larger than average increase in countries like such as Belgium, Spain, and the UK. A key reason why high inflation matters is because it squeezes real incomes and margins.

So let's turn to the outlook for growth. Now on growth, our baseline is of a slowdown in activity, but not a recession. We revised the eurozone estimate, growth estimate, from 1.2% in February to 0.8%, but the distribution of rates across different countries is quite wide. Now the slowdown comes through three, maybe, three different channels.

First one is through weaker consumption as high energy prices reduce real disposable income, and weigh on spending. Second channel is lower investment spending, due to a combination of high inflation and uncertainty and mostly tied to financial conditions, which make firms more cautious, particularly given that corporate profit margins have narrowed since early 2025 and currently stand below the long-term average.

And thirdly, we expect a slowdown in industrial activity. The biggest sensitivity remains in energy intensive sectors, sectors such as chemicals, basic metals, automotive sector. And these industries were already struggling with competitiveness issues due to higher energy costs, compared to the pre-2022 levels.

So why do we, we don't have a recession in the baseline? Well, we still see some support for the economy. Labor market conditions remain relatively solid. Banks are generally well capitalized, which limit the risk of a financial amplification mechanism. And, we still expect Germany’s fiscal stance to turn gradually more supportive with some positive spillovers regionally.

But there are also some important constraints. Outside Germany, fiscal space is limited. High debt levels, particularly in countries such as France and Italy, combined with structurally higher spending pressures coming from defense spending and aging population, reduced governments’ ability to cushion another shock.

And given Europe's low potential growth and openness, the economy can be tipped into recession by a relatively modest additional deterioration in energy prices or confidence. Very briefly, in terms of country exposure, the UK stands out as a relatively vulnerable economy given the inflation was already higher before the energy increase in energy costs.

Labor market conditions are softer, and fiscal space is quite limited. We've also downgraded German real GDP growth projections. This reflects reliance on imported energy and high share of energy intensive industry in its economy. And on the other side of the spectrum, economies that are less reliant on imported energy for example, Norway and France look better positioned to weather the storm.

I think one important point to, highlight is that the situation is a, very challenging situation for central banks or central banks are facing a classic trade off as inflation is moving away from target again but growth prospects have deteriorated. And since the start of the conflict, in late February, we haven't seen European central banks increasing policy rates. But importantly, we also haven't seen the cuts that markets had been expecting in some cases, for example, by the Bank of England the last month.

I think a good way to summarize our baseline in terms of monetary policy is that where we previously expected rate cuts, we now think central banks are more likely to stay on hold. This includes the Bank of England and where we previously expected no change, we now see limited upside risks to rates. For example, we forecast the ECB to increase its policy rates by 25 basis points to the second quarter of the year. A brief key point before I finish is that monetary conditions have already tightened even without central banks increasing policy rates, market rates have moved with repricing of inflation expectations.

And for example, if you look at the 12-month Euribor, which is a key benchmark for floating rate mortgages and corporate borrowing, has risen more than 45 basis points in late February, down from the peak of around 70 basis points in March. Now to wrap up compared to within the, compared to 2022, and based on the assumptions of base levels, assumption in terms of increasing energy prices, we think that the shock or the impact on the economy is going to be likely to be smaller, but still large enough to lift inflation, slow growth and delay rate cuts. Now that I'll stop here and I'll pass it on to my colleague Ben Herzon, who will go through the outlook for the US economy.

 

Ben Herzon:

Thanks, Diego. And let me just very briefly touch on the US outlook before I turn to the task at hand, just to focus on the fallout for the US economy before. So just very briefly, the US economy expands through this oil shock, albeit at a slower rate of growth, with more inflation and with a Fed that decides to stay on hold, and wait out this shock before resuming easing, in early 2027.

But let me focus on the topic at hand, which is fallout from the war in the Middle East. I think it's useful, to compare, the daily progression of oil prices and equity values to the August 1990 experience. Why August 1990? Well, that's when Iraq invaded Kuwait setting in motion the first Gulf War.

The result of macroeconomic shock combined with some underlying fragility in the US economy at the time led to the 1990-91 recession. So that's why we are closely following these two markers as we consider whether the shock the US economy is currently experiencing is sufficient to trigger a recession.

So over the two months, or roughly 40 business days, following the invasion of Kuwait back in 1990, oil prices rose by a hundred percent. So oil prices doubled and equity values fell, by about 15%. Now, for comparison, at the time we completed the current forecast, the April baseline forecast, which was about three weeks ago, oil prices were tracking along the same path, as they did in the 1990 experience, while equity values had declined by roughly one half the amount that they did in 1990.

Now what’s changed over the last few weeks? So since we completed the April baseline forecast, oil prices have broken below the 1990 path and equity values have more than fully recovered. So part of what's going on is, over the last few weeks, there have been ceasefires who are announced and there's simply less risk priced into both oil prices and equity values.

But I think there's something else going on as well. The fact that equity values have been so resilient comports well with the following observation: Back in 1990, about 8,000 British thermal units of primary energy were consumed to produce one real dollar of US GDP. Now, today, roughly half that amount is consumed to produce the same real dollar of GDP. So broadly speaking, the US economy is roughly twice as energy efficient as it was in 1990, and basically about three times as energy efficient as it was in the seventies, at the time of previous oil shocks.

So today the US economy is just better equipped to handle energy price shocks than it was back then. So, turning back to focusing back in on the April baseline forecast, the monthly path of oil prices that's assumed in the forecast translates to an average daily value of $112 per barrel during the second quarter. Now, this is well above what we were expecting back in February, in our February baseline forecast prior to the war. Oil prices are expected to remain elevated relative to our February projection for a couple of years.

Higher oil prices directly pass through to gasoline prices, and they also pass through to prices of, in the core, in the core index prices of services with a high energy component such as transportation. That's a good example. The result is that overall PCE inflation, rather than hovering around 2.5% as it does in our February forecast, quickly rises to 3.7%, early this year. And remains elevated through the balance of this of this year.

So how is the Fed expected to respond? Well, we don't think the Fed will ease or tighten this year. The only reason to ease with inflation running at 3.7% would be if the US economy were falling into a recession. We don't think that's happening. The only reason to tighten with labor markets not particularly robust at the time would be if inflation expectations were becoming unanchored.

So neither of these occur in our forecast. So the Fed is expected to remain on hold through early 2027. At that point, inflation in our forecast begins moving down and the Fed resumes easing. In the meantime, the extended pause keeps longer term interest rates above those that we showed in our February forecast. And financial conditions are generally tighter than we expected just a couple of months ago.