C.G.E. Bulmer | The Wilberforce Society | 4th February 2024
Edited by Jessica Alder
The 2020s have seen two major conflicts in two years: Russia’s invasion of Ukraine, and the escalation of the Israel-Hamas conflict to include Iranian-backed groups like the Houthis. As US hegemony diminishes, China looks increasingly towards Taiwan, and Russia forges links with anti-Western interests, Western central bankers need to place greater emphasis on global conflict amidst an emerging multipolarity. This article argues that recent events in the oil market, caused by cumulative global conflicts, have impacted the Bank of England’s monetary policy tools.
Monetary policy can be split into two components: conventional and unconventional. Conventional policy concerns interest rates – primarily the Bank of England Base Rate. Unconventional policy concerns Quantitative Easing (QE), which is carried out through the Bank of England’s Asset Purchase Facility.
While the Bank of England (‘the Bank’) has deployed conventional interest rate policy to deal with inflation from higher oil prices, it also faces current limitations on its unconventional policies. That is because rising oil prices have led to higher trade surpluses for oil exporters, which has led to higher foreign ownership of UK gilts. This situation has become more complicated due to ballooning government debt and the Mini-Budget delivered on the 23rd of September 2022.
The Impact of Conflict on Oil Prices
Conflicts have impacted importers and exporters of oil through (i) oil prices and (ii) oil shortages since Russia and the Middle East are key oil producers. Although the UK is a net importer of oil, shortages have been less relevant than prices with the UK still exporting £49.541B in gas, crude oil and refined oil in 2021. The UK has also been able to rapidly increase oil imports from the UAE, the Netherlands, Belgium, Saudi Arabia and India since April 2022 in response to Russian oil imports falling from £0.4B to £0.15B (ONS, 2023).
Oil prices are more complicated. Contractionary policies in the US, UK and Eurozone mean that it is harder to analyse the short-term impact of conflicts on oil prices since demand from major oil consumers has fallen. However, oil prices have been moving upward in the long term to above their levels of the last decade. Even though net global oil production has not decreased since 2020, Russian oil production has recovered from its 10% decline in April 2022. It remains high at 9.5 million barrels per day (Statista, 2023). There are two explanations for this.
Firstly, friction, de-integration and de-globalisation are leading to higher prices. Oil flows have changed since the invasion of Ukraine; Germany still demands energy imports, but from the US now its Russian energy imports have fallen to 0.1% of their pre-Ukraine value. Sanctions have failed to keep Russian oil being sold below the $60 per barrel limit (Politi, Cook, Sheppard, and Stognei, 2023).
Secondly, markets have been pricing in conflict and escalation risk. This seems likely since the escalation of the Yom Kippur War of 1973-74 resulted in the embargo of oil to Israel’s supporters, which caused a 300% rise in oil prices. Conflict with Iranian-backed groups has highlighted Iran’s ability to restrict oil flows through the Strait of Hormuz, through which 20% of global oil traffic passes (Bloomberg, 2023). Iran itself accounts for 4% of the world’s oil supply.
However, one should also look at conflicts from a cumulative perspective. Skidelsky (1979) claimed that cost-push inflation was the result of the growing power of international organisations like OPEC, in response to a dying US hegemony. This argument is becoming more relevant; the withdrawal from Afghanistan was followed by Russian aggression and rising conflict in the Middle East. Moreover, there is known communication between Putin, Iran, and now Hamas.
To summarise, the design of sanctions, disruption of oil flows and predictions in financial markets have led to sustained supply-side upward pressure, although in recent months this has been masked by falling demand. This upward pressure on oil prices has impacted the global economy via trade imbalances and inflationary pressures.
Rising Oil Prices and the Global Economy
Trade imbalances have worsened due to rising oil prices. Since the UK is highly dependent on oil imports, rising oil prices have led to a worsening of its already large current account deficit. Between January and May 2022, the trade deficit worsened as oil prices rose (ONS, 2023). Exporters face a different situation. The accumulation of USD (through the petrodollar system) or GBP from their trade surpluses impacts investment flows into the UK. Unless USD and GBP are held as reserves overseas, they usually re-enter the UK through investment in UK assets – most often UK gilts. In the first quarter of 2022, foreign ownership of gilts saw its largest increase in a decade (ONS, 2023). This coincided with Russia’s invasion of Ukraine, spiking oil prices and the UK’s largest recent current account deficit (-5.6% for 2022). The likely factors driving this are overseas demand for the security of Sterling, especially in the context of war on the euro area’s doorstep, and reinvestment of foreign trade surpluses in UK government debt.
Trade imbalances are significant, but inflation has received more attention. Some, notably Mervyn King (2022), argue that Western inflation post-Covid has been accelerated by the rapid expansion of the money supply and hesitation to increase interest rates until inflation is obvious; inflation was above target before the Ukraine war. This is certainly the case, but this article looks at the impact of conflict on the existing central bank framework post-Ukraine, imperfect as it may be.
The Monetary Policy Committee aims to keep inflation around 2%. Unfortunately, energy prices drove inflation to 11% in 2022 (Bank of England, 2023), despite the UK’s Energy Price Guarantee being a marked improvement on the failed price caps of the 1970s. Minton and Wheaton (2023) show how supply chains compound nominal rigidities to magnify the inflationary effects of oil price rises, while the structure of UK energy markets makes the UK particularly vulnerable to oil shocks (Haskel, 2023).
There is also a second-round effect of inflationary oil price supply shocks. Inflation expectations, which influence future inflation, have played a key role in recent central bank policy. Consumer behaviour is much more sensitive to energy price shocks than QE; the MPC’s most recent report shows how short-term inflation expectations spiked at over 10% once Western sanctions on Russian oil became apparent (Bank of England, 2023). The Bernanke and Blanchard (2023) model of price setting and inflation shows how an oil price shock can lead to a ‘catch up’ in wages which causes inflation to become embedded. When this happens, a monetary response is needed.
Conventional Policy Response
The Bank has been forced to deal with the inflation from oil shocks arising from global conflict. However, these oil shocks have also created constraints on monetary policy. This section looks at how conventional interest rate policy intends to deal with inflation.
In the November 2023 MPC Inflation Report, the oil price shock is judged as temporary, with expected 2024, 2025 and 2026 prices falling to $81, $77 and $74 per barrel respectively. Projected Bank Rate forecasts are at 5.1%, 4.5% and 4.2% respectively. That means as oil prices fall quickly, the Bank Rate falls at a slower pace. This is consistent with a New Keynesian model with adaptive expectations, where firms and households expect the next period’s inflation to equal that of the present. This emphasis on expectations shows how the Bank wants to avoid the wage-price spiral which followed the oil shocks of the 1970s.
Carlin and Soskice (2015) present a useful model for analysing oil shocks. It uses three variables: aggregate demand ‘AD’, the balance of trade equilibrium ‘BT’ and the equilibrium rate of unemployment ‘ERU’, all of which are functions of the real exchange rate, with the economy equilibrating where AD equals ERU.
One can compare the model with the Bank’s prediction of inflation, output and the exchange rate to see how it intends to deal with inflation. In its November MPC report, the Bank predicts a 1.1% appreciation of Sterling, followed by a 2.5% depreciation until 2026.
This currency appreciation (‘overshooting’), depreciation and a final move back to the equilibrium mean two conclusions can be drawn. Firstly, unlike in the 1970s, the focus is on inflation, not the reduction in aggregate demand arising from oil shocks. Secondly, the inflationary oil shock is expected to be temporary. This suggests that conventional policy (interest rates) are being used in the standard way in the short to medium term to deal with the inflation shock.
Global imbalances may lead to a change in the neutral rate of interest (the rate at which the loanable funds market equilibrates without intervention) if oil exporters’ trade surpluses rise or fall since that will adjust the supply of savings available in UK loanable funds markets. If this were the case, conventional interest rate policy may need to adjust so that rate hikes/cuts move relative to a new neutral rate. However, this may only be relevant in the longer term.
Unconventional Policy Response
Conventional policy responded to the supply shock as one would expect. The Bank has made clear that interest rate policy driven by the Bank Rate is their primary lever in the economy. However, there is an asymmetry in policy. During Covid, unconventional QE was the principal stimulus, yet now the £758Bn gilt QE portfolio remains “in the background” (Ramsden, 2023). Moreover, Monetarists assign at least some of the blame for current inflation to QE’s increase of M4x (a broad measure of money supply). The 11.6% reduction in the Bank’s Asset Purchase Facility (as of July 2023) hardly compares to the immense increase in QE since 2020, especially given that the Bank intends to “turn off” some of the reverse QE channels.
Monetary tightening is considerably less aggressive than it would appear from rate hikes alone as there is a lack of supply contraction. Why is reverse QE (‘Quantitative Tightening’) “in the background”? Rising overseas demand for UK gilts should, if anything, require more QT to reduce inflation.
This leads to the long-term implications for UK gilts. Reliance on overseas investors to prop up demand for UK government debt and keep interest payments down has worked so far, and foreign trade surpluses from oil shocks further allow this. However, the UK is vulnerable to capital flight more than ever, which threatens the stability of the UK gilt market.
Firstly, if conflicts escalate and restrictions are put on capital flows, the gilt market could become very unstable. On the other hand, if conflicts subside and the oil price falls, foreign investors may withdraw funding as oil exporters' trade surpluses fall.
Secondly, when domestic assets are held by overseas investors, such assets are vulnerable to currency depreciation; if UK interest rates fall faster than US or Eurozone rates, Sterling will depreciate. Expectations of this continuing will could lead to a sell-off of gilts by overseas investors.
Thirdly, unlike the US, the UK does not hold a reserve currency. This means the UK cannot withstand as high government debt levels as the US. Yet the UK faces a worsening structural deficit, not least because it may need to increase its defence spending beyond 2.1% of GDP.
These are major concerns. The Bank of England therefore may be unwilling to sell gilts in case it sparks a sell-off. The unexpected Mini-Budget in September 2022 increased the budget deficit, leading to a sell-off of gilts, and Sterling to crash towards parity with the US Dollar. This required emergency QE. Allowing some of the QE portfolio to run to maturity, with Treasury payments to the Bank (including interest) being handed back to the Treasury, supports this argument. Fiscal Dominance and Modern Monetary Theory were narrowly avoided during the pandemic, yet the Bank of England’s support of the gilt market creates a moral hazard which incentivizes higher fiscal deficits.
An attempt by the Bank to support the gilt market in this situation could compromise its inflation mandate as it is forced to increase the money supply to buy gilts, assuming holders of gilts are not spooked by this intervention (which has not yet been the case).
Moreover, the neutral rate of interest may rise if global savings markets are disrupted. Under this scenario, it is plausible that the Bank relies solely on conventional interest rate policies since the zero lower bound is no longer a policy concern. This would leave the Asset Purchase Facility unaccounted for, and support further long-term intervention in the gilt market. During the Great Moderation of the 1990s, stable prices were key as supply-led expansion drove growth. In the 2020s, with military action along supply chains, sanctions for energy suppliers and hostilities between saving and borrowing countries, inflation may no longer be the top priority.
Conclusion
Current conventional monetary policy treats oil price shocks as temporary and is focused on lowering inflation and inflation expectations in the short to medium run. However, the long-term pressures on the Bank of England are becoming increasingly important, and this can be seen in unconventional monetary policy.
A central bank whose main policy lever during Covid was stimulus to a huge, globally integrated government debt market is vulnerable to international conflict, irrespective of whether it was right to do so during Covid. These fault lines became visible after the invasion of Ukraine and will likely emerge again if the Middle East conflict escalates. Recent disputes between Venezuela and Guyana over territory and oil extraction licenses, with a UK warship being sent show how fractionalisation of oil markets is here to stay.
A conflict with China would also disrupt global lending on a much larger scale. Institutional pressures in the UK however would be less severe than elsewhere. Conflict in Ukraine has already forced the European Central Bank into this quasi-political domain, with the ECB having to decide which countries benefit and which lose out (Jones, 2022); Eurobonds, QT and divergent economies magnify these pressures. By far the largest threat is an economic chasm between the West and anti-Western interests with trade wars, capital controls and FDI restrictions. This would separate buyer and selling leaving central banks as market makers caught in the middle between competing objectives. Global conflicts might be the catalyst moving central banks into a new era of policy reminiscent of war financing.
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