Iran War Could Push A Flagging US Economy Over The Edge

We do know there will be disruptions to the supply of oil and liquefied natural gas, which is difficult to ship through the Strait of Hormuz, and from the fiscal costs associated with this military action.

As of March 9, the price of crude oil was hovering a little under $90 a barrel after reaching $118 a day earlier. That's up from $67 before the US and Israel began bombing Iran on Feb. 28, driving up gasoline prices across the US.

The majority of oil and liquefied natural gas produced in the Middle East travels through the Strait of Hormuz – but the threat of attack has made travel through this waterway uninsurable, which has brought shipping through this vital passage to a virtual halt.

This is also an expensive military campaign for the United States, which has already seen the loss of aircraft and a depletion of its stock of missiles. Early estimates of the cost of the war were nearly $1 billion a day.

The 1979 Iranian Revolution also brought about a spike in the price of oil, which was an important contributing factor to the US and Europe experiencing an economic phenomenon called“stagflation” – a portmanteau of stagnant growth and high inflation.

This is unlikely to be repeated to the same extent now. Economies are less dependent upon oil and natural gas than they were in the late 1970s and early '80s. And the US is not beginning the war with a previous decade of high inflation that made it more difficult to reduce price pressures, since expectations of inflation feed into actual inflation.

Still, supply shocks are challenging to address, as the world saw with the Covid-19 pandemic, and policymakers will likely have to make some difficult choices that involve hard trade-offs.

One of the questions arising from supply shocks is whether a central bank should raise interest rates to combat inflation or lower them to offset weakness in the economy and rising unemployment. Lifting rates brings down inflation by reducing demand for loans and curbing growth, while lowering rates has the opposite effect.

In both the late 1970s and during the onset of the pandemic, the Federal Reserve opted to keep rates low to help support the economy and the job market. In both cases, this led to a spike in inflation.

The inflation of the late 1970s and early '80s was brought down by a strong reversal of monetary policy with high interest rates, causing a recession that was, at that time, the deepest since the 1930s.

Notably, the reduction of inflation in the wake of Covid-19 did not require a similar economic downturn to achieve that goal. An important reason for that is the long history of low inflation in the decades before the 2020s and the“anchoring” of inflation expectations.