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The war in the Middle East and the associated oil shock is dominating economic discussions, policy and the outlook for the economy.

Oil prices have risen sharply and the distribution of oil has been significantly dislocated leading to concerns about the price and supply of petrol in Australia in the weeks and months ahead.

The price effects are obvious. Petrol prices (including diesel) are generally up 40 to 60 per cent in the past month which is impacting inflation, consumer and business confidence and household spending.

There is considerable uncertainty about where the peak in prices will be with conflict still festering and oil supplies severely disrupted. If oil prices remain high for an extended time, or indeed increase further, the inflation shock will be more acute. This will present particular difficulties for policy makers.

In addition to the obvious effects on inflation, the oil / petrol shock will also have a significant negative impact on economic growth. Household spending, in particular, is set to weaken perhaps severely, while rising transport costs will impact logistics and the distribution of goods. The agriculture and mining sector, both heavy users of diesel, could also weaken as profits are squeezed.

This gets to the issue of the trade-off that the RBA, in particular, will be forced to make – further hike interest rates to dampen inflation risks even though that will trigger a sharp rise in unemployment; versus keeping monetary policy less restrictive which will lessen the rise in unemployment but leave inflation well above its target for longer.

It is a genuine policy dilemma. 

What is also a significant uncertainty is the availability of petrol, particularly in some rural and regional areas. This has been driven by what might be termed ‘panic buying’ which has drained retail inventories. The mining, transport and agriculture sectors have experienced shortages in regional areas.

At this stage, the supply of petrol into Australia remains little changed and arrivals are orderly. According to Malcolm Roberts, Chief Executive of the Australian Institute of Petroleum, tanker deliveries are continuing with minimal disruption, and forward contracts are still being honoured. For now, at least, this augurs well for the restocking of supplies for the retailers impacted by the panic buying.

As is often the case with such economic upheavals, circumstances can change quickly. In the fickleness of the military action in Iran and the Middle East, crude oil supplies to the refineries in the Asian region could be materially cut at any moment. There could also be some form of a resolution which sees oil prices fall and supply chains repaired.

The optimistic scenario is one where some form of resolution to the conflict is soon and the distribution of oil from the Middle East recovers quickly.

There are early signs that the petrol shock, together with the two interest rate increases from the RBA in February and March, are impacting economic growth.

The purchasing managers index for services, for example, fell to 46.6 points in March, signalling a material slowing in the services sector. It is consistent with a contraction in activity.

The Roy Morgan-ANZ index of consumer confidence has free-fallen to a 53 year low as consumers react to the python like squeeze on their finances from higher inflation and higher interest rates and due to concerns that something even worse could be ahead. This is an extraordinary collapse in confidence and takes account of the petrol price rises.

Indeed, that level of confidence if sustained, is consistent with falling real household spending growth, which augurs poorly for bottom line GDP growth and employment.

Events in the Middle East and the oil market will dominate markets and policy maker’s deliberations in the weeks and probably months ahead.

Until the conflict is resolved, the downside to growth and upside to inflation will remain the order of the day.