LONDON, March 10 (Reuters Breakingviews) - It’s never a convenient time for war-induced spikes in oil and gas prices, as Russia’s invasion of Ukraine in 2022 can attest. But today’s flare up in the Middle East hits Western economies at a ​more fragile moment. Labour markets are looser, corporate margins thinner, and interest rates much higher than they were four years ago. Whether ‌governments shield households and firms from costlier energy or leave them exposed, the result is likely the same: borrowing costs will climb.

Bond markets are already tense. Even after Donald Trump on Tuesday predicted rapid de escalation with Iran, 10 year yields in Germany, France, the United Kingdom and Japan remain well above their pre crisis levels. Unlike the United States, all are large ​net importers of energy and particularly natural gas, which plays a key role in setting electricity prices.

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Yet, if disruption at the Strait of Hormuz ​persists, governments may be forced to brave hostile debt markets and once again fund energy price caps, subsidies and tax ⁠cuts. South Korea has already moved in that direction, and UK Prime Minister Keir Starmer signalled on Monday that Britain may follow. Bruegel’s data on Europe’s last ​energy shock shows how expensive such measures can be: between September 2021 and January 2023, they cost European countries – including the UK – 3.7% of GDP. This would ​sit atop the 3.4% deficit that official projections, opens new tab had already pinned on the European Union for this year.

But inaction would lead to a similar place. The post-pandemic experience showed that companies react to energy shocks by coordinating price hikes to protect their margins, opens new tab, which is why even “core” inflation in the U.S., the eurozone and Britain – which excludes the price of fuel and food – peaked ​at range of between 5.7% and 7.1% in 2023. In theory, central banks should look through one off energy shocks; in practice, this so-called pass through ​effect forces them to respond. Markets have already shifted from expecting year end rate cuts at the Bank of England and the European Central Bank to pricing in a hike ‌from the ⁠former and no change from the latter, according to derivative prices collected by LSEG.

The inflation hit should still be smaller this time. European natural gas trades around 50 euros per megawatt hour, far below the 300-euro peak of 2022. Deutsche Bank’s Sanjay Raja estimates that even a generous UK support package would total only 14 billion pounds, or 0.4% of GDP, compared with 90 billion pounds previously. Still, that extra fiscal hit comes at a time when government tax revenues are already ​strained by low growth. The danger is ​that more, potentially open-ended financial commitments ⁠push up bond yields, making the fiscal math even trickier.

Central banks could help break the feedback loop with a clear pledge to backstop sovereign bond markets, as the ECB did during the pandemic. At the margin, energy subsidies might help ease ​fears of a price spiral. But the current level of inflation, which is at or above target in the ​EU and UK, means ⁠ratesetters probably won’t act unless bond markets are under extreme duress. If the Iran war continues, government coffers could become a pain point.

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Context News

• U.S. President Donald Trump predicted a quick end to the war in the Middle East on March 9, even as it threatened Iran with further military escalation if it thought ⁠to block ​oil shipments in the Strait of Hormuz.
• As of 0900 GMT on March 10, Brent oil prices ​traded at $93 a barrel, and German, French, British and Japanese 10-year government bond yields at 2.8%, 3.5%, 4.6% and 2.2%, respectively, compared with $72, 2.7%, 3.2%, 4.2% and 2.1% before the U.S.-Israeli attack on ​Iran.

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Editing by Neil Unmack; Production by Shrabani Chakraborty

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Jon Sindreu

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Jon Sindreu is the London-based global economics editor for Breakingviews. He was previously a reporter and a columnist for the Wall Street Journal, where he covered macroeconomics, financial markets and aviation for 11 years. He holds a master’s degree in financial journalism from City St George’s, University of London. He also holds degrees in computer science and journalism from Universitat Autònoma de Barcelona, in his natal Catalonia.

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