Middle East Conflict Presents Two-Sided Risks for RBNZ

Geopolitical Risks and the RBNZ's Policy Stance

The recent surge in crude oil prices, fueled by escalating hostilities in the Middle East, has ignited widespread apprehensions regarding potential inflationary spirals and subsequent tightening of monetary policies by various central banks globally. However, the Reserve Bank of New Zealand (RBNZ) faces a unique predicament, given the nation's fragile economic foundation. While many nations grapple with the prospect of rising inflation, New Zealand's circumstances necessitate a more nuanced approach.

The spike in crude oil and petroleum prices, triggered by renewed conflict, has prompted markets to brace for a sustained period of elevated inflation and restrictive monetary policies from central banks committed to inflation targeting. In New Zealand, however, the presence of considerable spare capacity mitigates the risk of secondary inflationary effects stemming from a temporary surge in petrol prices. Considering this backdrop, dismissing scenarios that could potentially lead to further policy easing would be imprudent.

Such a scenario could materialize if the conflict precipitates a significant downward revision of the global growth outlook and commodity prices, thereby impeding New Zealand's nascent recovery and jeopardizing the medium-term inflation outlook. In the interim, confronted with these dual uncertainties, the RBNZ is expected to reinforce its "on hold" stance, as articulated during the preceding month's meeting.

Market Impact and Economic Implications

The primary catalyst driving both domestic and international financial markets in recent weeks has been the intensification of conflict in the Middle East. The most immediate and enduring consequence has been the surge in crude oil prices and other critical energy commodities. Brent crude, for instance, has risen by $13 per barrel, reaching $85 per barrel. This increase compounds the gains observed throughout January and February, as market participants anticipated the unfolding conflict.

The price escalation in refined petroleum products has been even more pronounced, accompanied by a widening of refiners' margins, a typical phenomenon during crises that raise concerns about refinery capacity. Concurrently, safe-haven capital flows into the US dollar have exerted downward pressure on the risk-sensitive New Zealand dollar, depreciating it by approximately 2% to below 0.5900. This exacerbates the local currency impact of higher US dollar-denominated energy prices. Global equity prices have experienced slight declines, while term interest rates have edged higher, reflecting apprehensions regarding the potential impact of elevated oil prices on inflation and central bank policies.

New Zealand's Exposure and RBNZ Considerations

New Zealand's economic vulnerability hinges on the duration of the military conflict and the extent of disruption to international supply chains. A swift resolution, with minimal damage to energy infrastructure, would likely result in negligible economic repercussions for New Zealand and its trading partners. Conversely, a protracted conflict, particularly one causing substantial disruptions to oil supply or precipitating significant declines in financial asset prices, could have more pronounced adverse effects.

While New Zealand's direct trade with Iran is limited, its exports to the broader Middle East region have surpassed $3 billion in the past year, primarily consisting of dairy products destined for Saudi Arabia and the United Arab Emirates. Protracted conflict would pose logistical challenges for exporters and elevate business costs. Moreover, disruptions to airspace in the Middle East would impede the movement of both people and goods, negatively impacting inbound tourism. The RBNZ's standard approach is to look past near-term inflation caused by higher oil prices, especially when it reflects a supply shock. The central bank will likely maintain its current policy stance, closely monitoring the conflict's impact on the economic outlook and medium-term inflation trajectory.

RBNZ Governor Breman is scheduled to address a Business NZ CEO Forum on March 24th, potentially offering insights into the central bank's evolving perspective. The RBNZ is expected to communicate a more dovish message compared to current market pricing, which this week has been leaning towards a greater chance of the OCR being hiked sooner than December.