What if the Middle East unrest causes an oil shock?

The last thing the global economy needed right now was an oil shock.  

Soaring food prices, alongside already high commodity prices, have created inflationary pressures and if oil prices were to rise by another $20 over the coming months there is a real danger the global economy could tip back into recession, according to analysts.

As troops fired on anti-government protesters in Libya the price of Brent Crude futures shot up by a little under $2 a barrel and above $104. The rise was the highest daily leap in three weeks and is a sign that traders are concerned that the unrest will spread to other Middle Eastern countries.

Such a scenario could have severe implications for the oil price. The region accounts for some 36% of oil reserves and if companies like BP, which is pulling its contractors out of Libya - are forced to evacuate the region the west could find itself having to pay major premiums to satisfy its hunger for oil.

Higher oil price increases deflationary pressures

But while jumps in the oil price cause inflation to rise at the headline level, it also has an adverse impact on economic activity, reducing demand which naturally serves as a deflationary force. This happens in a number of ways as higher fuel costs hamper a firm's production, which in turn forces it to lay off workers while also reducing wage pressures.

Analysts at UBS believe a $10 hike in the oil price would push up European inflation by 0.2% over one year and 0.1% over two years. They do not believe further oil prices would necessarily translate into significant inflation because of the countering deflationary forces.

According to the investment bank's simulations a jump in oil prices pushes up the energy component of the inflation index but depresses core inflation, which excludes volatile food and energy prices.  

Analysis from the bank shows that a 10% increase in crude reduces core inflation by 0.1% a year after with the deflationary effects of oil shocks seem to take longer to disappear with projected core inflation still well below the non-shock level. This is because the shock is estimated to reduce economic activity for more than two years. In a extreme case scenario where the price of oil rises by as much as $50 core inflation subsequently drops by 0.25%.    

For this reason UBS does not expect European central banks to be knee-jerked into action if the oil prices continue to rise amid the Middle East tensions.

'An eventual oil shock would hit the EU economy in an environment of low inflation expectations and wage deflation,' UBS says. 'For this reason we think the ECB would not be too worried about second-round effects, and would therefore not be forced to hike rates earlier.'