A drawn-out war in the Middle East could add an extra 5% to existing inflation in Australia, our new modelling shows.

We looked at the likely impacts of two different scenarios: a moderate disruption with the war ending in mid-April, and a drawn-out war ending by September.

We found higher fuel costs would affect freight, food production and manufacturing – pushing up costs for all kinds of goods, from steak to steel. At the same time, economic growth is likely to slow.

If both pressures persist, Australia faces the risk of a painful combination known as “stagflation^[1]”: rising prices and a slowing economy.

But if there’s any silver lining in our new modelling, it’s that Australia would fare better than some of its nearest neighbours, including Singapore, Thailand, Japan and South Korea.

Two different futures

To analyse where things might be headed, we used an advanced economic modelling tool called the Global Trade Analysis Project model^[2]. This model is widely used in international trade and energy policy research.

It allows us to trace how an oil price shock spreads through trade, production costs, industry output and household spending across the global economy.

Our moderate scenario assumes a disruption lasting six weeks in total – meaning it’s over by mid-April – with the Brent crude oil price settling at around US$90–$100 (A$130–$145). This is in line with other baseline modelling^[3] by insurance firm Allianz, where a ceasefire is negotiated.

Our severe scenario assumes the conflict goes on for six months in total, ending by around September, with the price of Brent crude at US$100–$150 (A$145–$218).

Inflation was at 3.7% over the 12 months^[4] to February – before the war broke out.

However, our modelling doesn’t predict total inflation in April and September – only the extra inflation caused.

Just a short blip

Under the moderate scenario, Australia’s economy experiences relatively minor effects. Gross domestic product (GDP) would be lower by about 0.02% and consumer prices would rise by 0.6% on top of existing inflation.

The impact would be largely concentrated in the energy sector. Most industries would take a small hit, as the costs of their inputs rise marginally. At the same time, however, Australia’s oil and gas extraction would be likely to expand, as higher global prices make domestic production more profitable.

Australia’s terms of trade^[5] – the ratio of how much it gets paid for its exports to how much it pays for its imports – would actually improve by about 1%. This reflects its role as an energy exporter. But the benefits would largely go to the resource sector, not to households facing higher costs.

A drawn-out war

Our severe scenario is where the numbers become alarming. GDP would contract by 0.16%, roughly eight times the moderate impact. Consumer prices would surge by 5.1% by around September this year.

The impacts in different sectors show a clear transmission chain from oil shock to other disruption.

Energy-intensive industries would be hit first: output from Australian refineries would shrink by 25%, as input costs surge. Steel and metal production would fall by 15%, and chemicals production by nearly 14%.

Rising fuel costs would then feed into freight, with the transport sector’s costs jumping 7.7%. This would impact everything that travels by truck, rail or ship.

Agriculture and food production – industries at the heart of the Australian economy – would likely absorb the shock next.

Australia’s meat and livestock production could fall nearly 7.6%, and processed food by 4.4%. At the same time, the total production cost would go up by 3–5%. Those higher costs would mostly be passed on to consumers.

The only sector that would be likely to expand is natural gas extraction itself, but its gains are concentrated in a narrow slice of the economy and workforce.

Australia’s neighbours fare worse

Australia’s GDP impact, while significant at home, is considerably smaller than that of some of its import-dependent Asian neighbours.

Under the severe scenario, our modelling estimates Singapore’s GDP takes a 4.7% hit. South Korea’s GDP is 4.4% lower, Thailand’s is 3.3% and Japan’s is 2% – all higher than Australia’s 0.16% reduction.

The pattern is clear: the greater an economy’s dependence on imported oil, particularly from the Middle East, and the less it produces domestically, the larger the hit.

Australia sits somewhere in the middle. Its energy exports (particularly liquefied natural gas) partially shield it from the shock. But it’s still exposed through depleted capacity to refine oil.

Australia only has two oil refineries left^[6], both on government subsidies (which have now been extended to 2030^[7]).

The ‘stagflation’ trap

History shows countries need to be very careful in responding to an oil shock. Japan’s response^[8] to the 1970s crisis^[9] is a textbook case of what can go wrong.

Japan’s interest rates were already too low before the crisis, with inflation exceeding 10% by mid-1973. When oil prices spiked later that year, Japan had already raised rates, but only slowly.

By spring of 1974, inflation was up near 25%, triggering a prolonged period of “stagflation^[10]”.

Something similar could happen today, if governments respond by subsidising fuel or lowering interest rates.

Australia faces this dilemma now, and there’s no easy solution. With inflation already at almost 4%^[11], and interest rates at 4.1%^[12], the Reserve Bank of Australia is already fighting inflation.

Lowering interest rates could embed consumer expectations that prices will keep rising. But keeping rates higher worsens the cost-of-living squeeze and slows the economy.