The war in the Middle East tests the recovery momentum of the US economy

Last weekend, the US and Israel attacked Iran, with the goal of eliminating the threat from Tehran’s nuclear and missile programs to the national security of the world’s largest economy. The conflict has lasted for the fourth day, spreading to many countries in the Middle East.

The war caused world crude oil prices in the March 2nd session to increase from 70 USD to nearly 80 USD per barrel, then cool down somewhat. Meanwhile, shipping activities through the vital waterway – the Strait of Hormuz are almost paralyzed.

The US is less affected by the energy shock than other developed countries, thanks to its large oil and gas exploitation output. However, fighting could still impact trade, prices and investment, weakening the positive growth outlook that is building this year.

A recent survey by the consulting organization Conference Board shows that CEOs’ confidence in the US economic outlook and their industry has increased sharply. However, nearly 60% think that the risk of geopolitical tensions causing economic disruption is currently very high.

In the latest report, the World Bank (WB) assessed that the US economic outlook is “upbeat”, but this scenario is threatened by unpredictable conflicts in the world’s key oil producing region. The war will cause many consequences for shipping, supply chains and global commodity prices.

Last year, the US economy grew by 2.2% – the slowest in 5 years. “Data from earlier this year shows that businesses have begun to overcome the freeze in recruitment and capital spending. However, military conflicts and trade instability may raise concerns about US economic recovery and global stability,” Joseph Lupton – economist at JPMorgan said last weekend, after the US airstrike on Iran.

The impact on the US economy and the monetary policy of the US Federal Reserve (Fed) also depends on the increase in oil prices and the risk of conflict escalation. “The war with Iran is an unpredictable variable,” said analysts at SGH Macro Advisors.

Similarly, lessons from the Russia-Ukraine conflict in 2022 also pose similar risks to the US economy. The Fed’s initial response was easing, as officials reduced the scale of plans to sharply increase interest rates. But then, their concerns quickly turned back to inflation, causing the cycle of interest rate hikes to accelerate.

However, the initial impact of tensions in the Middle East this time on the market is still under control. Interest rate futures contracts are slightly tilted towards the possibility of the Fed tightening, but still maintain expectations that the agency will adjust interest rates twice this year, starting in July.

Yields on 2-year US Treasury bonds last week went down. This is a common reaction during times of volatility, when investors seek shelter assets. However, yields increased sharply again in the first session of the week, reflecting inflation concerns and rising risks. The USD, another haven asset, increased in price compared to a basket of major currencies in the first session of the week. Major US stock indexes were almost unchanged.

“We do not think that geopolitical developments have a major impact on the Fed’s interest rate plans. Inflation risks are offset by domestic data. The economy is forecast to create an additional 55,000 jobs in February, and the unemployment rate is around 4.4%. This level is enough for the Fed to believe that the labor market is stable,” said analysts at Citi.

Meanwhile, at an S&P Global conference on March 2, former Fed Chairwoman Janet Yellen said that the war risks driving up US inflation and slowing growth. This “makes the Fed even more cautious and hesitant to reduce interest rates.”

The world is watching the unpredictable developments of war in the Middle East. “Risks increase significantly,” said Christopher Hodge, chief economist for the US at Natixis CIB Americas. He presented many scenarios, from the conflict being resolved soon and Iran having a new government, to a prolonged tension that upsets global supply chains.

Hodge analyzed that if Iran’s response is not significant, the impact on oil prices will quickly decline and cause only a relatively small economic impact. At that time, the Fed’s interest rate policy was almost unchanged.

On the contrary, if the conflict spreads in the region, causing spillover effects on trade routes and global supply chains beyond the energy sector, oil prices will remain above 120 USD a barrel, an increase of 50% compared to the present. At this time, the shock will no longer be limited to the energy sector. Vital shipping routes were disrupted, insurance costs skyrocketed and global production networks were affected. The consequence is that the US may record negative growth, increased unemployment, large budget deficit and the Fed must quickly reduce interest rates to prevent recession.