Special Report
March 03, 2026 | 12:34
Conflict With Iran: Economic Implications
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Now that we have a clearer grasp of the parameters around the conflict with Iran, with U.S. President Trump suggesting it could last four-to-five weeks, and Iran threatening to shut the Strait of Hormuz, we can better assess the potential economic impacts. First, the initial, muted market reaction appears to have understated the risks involved, and there are significant possible implications for the global economy. But, second, there is still a great deal of uncertainty, and we have considered a range of scenarios for the net impact on the forecast. Clearly the key variable for the outlook is the impact of the conflict on energy prices. After an initially mild response, WTI has bounced another 7% on Tuesday to around |
It’s early days, and the war has already provided a number of surprises; notably, the suspension of passage through the Strait of Hormuz, and attacks across many Gulf countries. It is possible that the war lasts longer than some expert predictions of a few weeks. There are many risks that could arise, e.g., damage to regional energy infrastructure in Iran and other Gulf countries. Iran could also have built up a much larger stockpile of weapons (especially drones) since last year's Twelve-Day War, which would prolong the conflict. And, one cannot completely discount the possibility of the Strait of Hormuz being effectively closed for an extended period. In other words, crude oil prices are likely to remain highly volatile for a while yet. Of the four scenarios we considered (see accompanying Table), a few see the price spiking temporarily above $100, but most look for a return to the mid-$60 range by the fourth quarter of the year. But, given the high degree of uncertainty, we have taken a weighted average of the scenarios to determine our new forecast for WTI prices. That raises our baseline assumption to just under $69 for 2026, which compares with our earlier assumption of $60. (For perspective, WTI had averaged just above $60 over the past six months.) |
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Implications of the higher base price for oilInflation: A sustained rise in oil prices will lead to a temporary bump higher in inflation. For the U.S., our baseline scenario pushes oil prices up 34% on average by June relative to our previous forecast and 15% higher for all of 2026. That would lift headline inflation by roughly 0.7 ppts in the near term and 0.3 ppts for the year, and the core rate by 0.3 ppts and 0.1 ppts, respectively, from where it would have otherwise been (see Appendix for more details). The inflationary impacts in Canada could be in line with those in the U.S. given similar shares of gasoline in the CPI. Growth: It would take a fairly significant shock in oil prices to meaningfully weigh on the U.S. economy. Growth is not as sensitive to oil prices as in the past, in part owing to the fact that the U.S. is now a net exporter. Our weighted average scenario would likely not quite meet the threshold of driving U.S. growth lower, although the risk is clearly that GDP could be shaved as a result of higher energy prices, less Fed easing and the dampening effect on confidence. The Canadian economy is even less vulnerable to higher energy prices, given its status as a major exporter. However, a weaker global growth backdrop could impact the domestic economy. Higher energy prices would support growth in the energy-exporting provinces, while weighing on spending in the rest of the country. At this point, we would not be reducing our call on Canadian GDP growth, but instead flagging the risks from moderately higher inflation and a somewhat softer global backdrop. Market impactsConflict is not new for markets or the economy. The response in each episode depends on the scope/duration of the event, if supply of certain goods (e.g., oil) is choked off, and how much had already been priced in beforehand. There is no one-size-fits-all response. Indeed, the Gulf War brought a sharp but short surge in oil prices; the Iraq War actually saw prices fall immediately as a risk premium was already built in; and the 2022 Russian/Ukraine conflict saw a temporary spike in prices followed by a lasting premium through roughly a year. Looking back at three major conflicts since 1990, here are some key takeaways: Monetary policy and rates: While inflation will likely tick up if oil price increases persist, the central bank response is somewhat cloudy given a negative supply shock is, in theory, negative for growth at the same time. In the past, the net inflation pressure for the shock hasn’t necessarily triggered a monetary policy response on its own, but it can certainly reinforce central bank thinking. During the Russia conflict, for example, the Federal Reserve immediately tightened—but inflation was accelerating post-pandemic, and the FOMC was already set to do so. Now, this shock may keep the Fed from easing even longer if it draws on. The market is currently pricing in just over 40 bps of easing in 2026, already scaling back expectations somewhat. Longer-term Treasury yields also risk heading higher if higher oil prices persist and become embedded in inflation expectations, and less/delayed Fed easing creeps up the yield curve. At the same time, the fiscal impact of higher military spending, at a time of an already-deep budget hole, will be on the market's mind. For the Bank of Canada, few expected a rate move this year even prior to the conflict. But the potential upward pressure on inflation has further reduced the small chances of a cut this year. On Monday in Oslo, BoC Deputy Governor Kozicki said that a supply shock that boosts costs notably without seriously damaging the growth outlook would make the Bank more biased to tighten policy. While her remarks were not aimed specifically at the conflict, a jump in oil prices could fit the bill. This is not to suggest that we expect a hike as a result of the conflict, but it drives home the point that further rate relief is less likely, even if the economy is struggling with trade uncertainty. For those other central banks that have already begun to tighten, the pressure is rising to continue doing so, perhaps at a faster rate. The Reserve Bank of Australia said Monday night that every meeting is now live and the Bank of Japan—a huge importer of energy—may also be harbouring similar views. Meantime, the jump in European natural gas prices is also jolting the European Central Bank. Equity markets: Stocks tend to move on in aggregate, but it can take some time. The S&P 500 sold off just shy of 20% in the lead-up to, and during, the early-1990s Gulf War. Performance during the Iraq War was much less negative, but the market then was coming off the post-tech bubble floor. The Russia-Ukraine conflict also coincided with a short-duration bear market in equities, but that was arguably more the result of the emerging tightening cycle. At the highest level, broader macroeconomic circumstances matter most, and the conflict acts as a swing factor. Below the surface, energy and defensives have outperformed, and the TSX has held up relatively well given exposure to resources. At this time, the concern is that a negative supply shock will run into already-lofty tech valuations and chip away at Fed easing expectations—probably a difficult combination for those extended pockets of the equity market. Currencies: Currencies of oil/resource exporters tend to outperform (e.g., CAD, MX, AUD) during sustained oil supply shocks, while importers tend to lag (e.g., EUR, JPY). That said, flight-to-quality will likely drive short-term USD strength, at least until a clearer fundamental picture emerges. The greenback is now up about 2% in the past week, with notable strength against the European currencies. In contrast, the Canadian dollar has barely softened versus the greenback on net, supported by Canada’s net energy exporter status, although it can't fully escape the impact of risk-off sentiment. |
Appendix: U.S. Economic ImpactsThe Iran war’s impact on the U.S. economy will depend on its influence on inflation and interest rates, financial markets (equities and corporate credit spreads), and consumer and business confidence, offset partly by increased defence spending. Under Scenario 1, an assumed limited impact on financial markets and confidence implies that most of the adverse effects would stem from somewhat higher inflation and interest rates. Based on work by the Dallas Fed, a 10% rise in gasoline prices (stemming from a similar increase in oil prices) could raise PCE inflation by about 0.2 ppts within two months, before quickly fading, with minimal effect on core inflation. Under Scenario 1, a 25% average rise in oil prices between March and June relative to our previous baseline forecast could lift inflation by 0.5 ppts in the near term. The increase in core inflation (based on an elasticity of 0.08 ppts per 10% rise in gasoline prices) would be much smaller at just under 0.2 ppts, while one-year inflation expectations (elasticity 0.3 ppts in the first few months before fading) would rise 0.8 ppts, and longer-term inflation expectations (elasticity 0.05 ppts) would rise a tenth. Long-term Treasury yields would increase modestly in this scenario, likely by less than 20 bps, due to higher inflation expectations. For all of 2026, with oil prices 11% higher than our previous baseline, the inflationary effects would be reduced by more than half compared with the near-term impact, with PCE inflation about 0.2 ppts higher and core inflation less than a tenth above the previous baseline. If the Fed looks past the temporary inflationary impacts, it might still resume rate cuts in June. The impact on real GDP growth would be negligible, though the risk to our current 2.5% call for 2026 would tilt to the downside. Under Scenario 2, with an average 34% rise in oil prices by June relative to the previous baseline, headline inflation would increase 0.7 ppts by the summer, with core inflation up about 0.3 ppts and near-term inflation expectations jumping 1 ppt. For all of 2026, with oil prices 14% higher than our previous baseline, inflation would be 0.3 ppts higher, with the core rate a tenth higher. But even this scenario may not delay Fed easing, and would still have only a modest impact on GDP growth, assuming oil prices fall sharply in the second half of the year. It’s under the more severe Scenarios 3 and 4, with oil prices 59% and 80% higher than the previous baseline in the near term, respectively, and 25% and 35% higher this year that the economic damage would likely mount. Headline inflation could be 1.2 ppts and 1.6 ppts higher by the summer, with the core rate about one-half ppt higher and short-term inflation expectations spiking nearly 2 ppts in the two scenarios. For all of 2026, headline inflation could be just over one-half ppt higher and the core rate one-quarter ppt higher in the two scenarios. The 75 bps of Fed rate cuts in our previous baseline forecast for this year could be nixed. Assuming some knock-on effects to financial markets and confidence, the economy would likely struggle to grow 2% this year. Based on a weighted average of the four scenarios, with oil prices up 34% on average by June relative to our previous baseline and 15% higher for all of 2026, the impacts would mirror those of Scenario 2. |