The International Monetary Fund (IMF) has cautioned that if ongoing geopolitical conflicts continue to drive high energy prices and cause inflation expectations to become unanchored, global economic growth could fall to the 2% recession threshold. Central banks must be prepared to counter inflation with larger-than-expected interest rate hikes, even as they tolerate short-term supply shocks.
Repeated disruptions in the Strait of Hormuz have pushed Brent crude futures back toward the psychological barrier of $100 per barrel. Recent inflation data from the U.S. and Europe show a sharp rise in fuel prices driving a noticeable uptick in inflation. Year-over-year inflation in both the U.S. and the U.K. climbed to 3.3% in March, leaving major developed-economy central banks in a difficult position.
In a recent interview, Deniz Igan, Director of the IMF's World Economic Studies Division, advised central banks to maintain a watchful stance. "As long as the disruptions from the conflict remain contained, a reasonable policy response is to temporarily tolerate or look through the negative supply shock," Igan stated. However, he clarified that "temporary tolerance does not mean inaction. If inflation expectations continue to rise, central banks must decisively raise nominal interest rates, and the increase must exceed the rise in inflation expectations."
The conflict between the U.S. and Iran is significantly impacting the global economic landscape. Under the IMF's "severe scenario," global growth could fall to the 2% critical point. "It is worth noting that since 1980, global growth has fallen below this level only four times, most recently during the global financial crisis and the COVID-19 pandemic," Igan added. The IMF considers global growth below 2% as being "close to a global recession."
**How Close is the Global Economy to Recession?**
In its latest World Economic Outlook reference forecast, the IMF lowered growth expectations for all major advanced economies except Japan. Concurrently, projected inflation for advanced economies was revised up to around 2.8%, an increase of 0.6 percentage points. Regarding this trend, Igan explained that their reference forecast outlines a potential path amid significant uncertainty. The global economy had shown resilience until February, but the new shock from the Middle East disrupted the calm. Without this conflict, the IMF would have raised its 2026 growth forecast. Directly affected by volatility in commodity markets, the IMF now projects global growth to slow to 3.1%, with global inflation rising to 4.4%. This necessitates that policymakers remain highly flexible and adaptive, prepared to act decisively if conditions worsen.
The World Economic Outlook also discusses a "severe scenario" where global growth could be reduced by 1.3 percentage points, falling to approximately 2%. When asked how close this would bring the global economy to the 2% recession red line if the conflict persists until the end of 2026, Igan noted the extreme difficulty of predicting the war's end. The report includes two alternative scenarios, one being the severe case. Under this assumption, the conflict would extend into 2026, with physical damage to regional energy infrastructure causing commodity prices to remain high into 2027, inflation expectations to become unanchored, and financial conditions to tighten significantly, ultimately potentially pushing global growth down to 2%. He again emphasized that global growth has fallen below this level only four times since 1980.
**'Temporary Tolerance Does Not Mean Inaction'**
If the Strait of Hormuz remains closed for an extended period, how soon might inflation expectations in Europe and the U.S. become unanchored? Igan stated that before the conflict, inflation expectations were broadly anchored near targets. Now, short-term expectations have risen sharply. Following the 2022 Russia-Ukraine conflict, it took about a year for inflation expectations to begin shifting upward, but the current risks are greater. Households have fresh memories of the post-pandemic inflation surge, and cost-of-living pressures are high, meaning "second-round effects" could occur faster and more forcefully than in 2022. Furthermore, as a net energy importer, Europe faces more direct inflation transmission risks from a segmented natural gas market than the U.S.
With U.S. CPI rising to 3.3% in March, showing signs of reacceleration, is the possibility of interest rate hikes back on the table, despite the IMF's current advice for central banks to watch and wait? Igan reiterated that as long as disruptions remain limited, the reasonable policy response is to temporarily tolerate the negative supply shock. However, he stressed that "temporary tolerance does not mean inaction"; it implies maintaining the current stance to keep real interest rates stable. Additionally, central banks must be prepared to communicate their readiness to act swiftly. If they observe a sustained rise in inflation expectations, they must intervene decisively, which would require raising nominal interest rates by more than the increase in inflation expectations.
The U.S. is both a net energy exporter and a nation highly sensitive to oil prices due to its reliance on automobiles. How do these opposing forces affect the U.S. outlook? Igan described high energy prices as a double-edged sword for the U.S. On one hand, high oil prices can dampen consumption, though food and energy constitute a relatively small share of U.S. consumer spending. On the other hand, high prices incentivize domestic energy investment, and this positive supply-side response can offset negative impacts on consumption. Furthermore, U.S. fiscal policy and stronger-than-expected productivity growth have also provided a buffer. Consequently, the IMF still expects the U.S. to maintain solid growth of 2.3% in 2026ril, although prolonged conflict remains a key risk.
**'Preparing for the Next Test'**
The IMF lowered its growth forecast for Emerging Market and Developing Economies (EMDEs) by 0.3 percentage points to 3.9%, while the forecast for advanced economies remained largely unchanged. Why are the shocks hitting emerging markets harder? Igan explained that the overall aggregate adjustment masks significant regional divergence. Notably, the cumulative growth forecast for low-income net energy importers was revised down by 0.5 percentage points. Geopolitical conflicts transmit through three main channels: the direct hit from higher commodity prices, second-round effects on inflation expectations, and the amplification effect of risk aversion in financial markets. Emerging markets suffer more because households spend a larger share of their income on food and energy, and currency depreciation further erodes purchasing power. Additionally, inflation expectations are harder to anchor in these economies, and financial buffers, such as foreign exchange reserves, are typically smaller.
Recent discussions among Gulf states about building new pipeline infrastructure raise the question of whether this signals a structural shift in energy logistics rather than a simple return to the status quo. Igan suggested it is too early to draw conclusions, but we are in an environment where global supply shocks are becoming more frequent. The IMF advises member countries to calibrate policies not only to address current shocks but also to prepare for the next test. This means focusing on the energy transition, adopting renewable energy and energy efficiency systems, which can not only mitigate the pass-through of energy price volatility to inflation but also enhance resilience to future shocks by improving energy security.
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