Merlin Weekly Macro: The Gulf war has let the inflation genie out

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Growing pains of a conflict

Trump and Tehran are locked in a Mexican standoff in the Gulf conflict. At $120 per barrel, the price of Brent briefly surpassed the peak achieved when Putin invaded Ukraine in 2022, exactly double the price at the end of December 2025. Who knows who or what will break the geostrategic deadlock in the Straits of Hormuz or when; not even Donald Trump has the answer. The trickle-down consequence is already evident. A small selection of examples: while less dramatic than the increase in the price of crude oil, downstream in the plastics processing markets for items ranging from packaging to binbags, laptop cases and medical devices and many more, the price of oil-derived polymer raw material is up 34% year-to-date and physical shortages are appearing; in food, thanks to the shortage of fertilisers, US wheat has increased in price by 23% over the same period, while the London quoted price is up by 15%.

The oil futures price remains above $90 all the way out to October, still 50% higher than at the beginning of the year. Manufacturers are warning of the inflation momentum that is already locked into the system. Even if the oil market immediately returned to the status quo ante, the pernicious effect of highly elevated prices will take months to unwind. However “transitory” (to use the term that was so prevalent in 2022/3 and the big inflation spike) the inflation problem is perceived as being, thanks to the duration of global supply chains there is a risk of it taking longer than many expect to get back to normal. There is only so much that can be absorbed internally by companies before profitability is severely affected (consider the deferred effect: as a businessman observed manufacturers ordering components from China today may not receive them for two months if they come by sea; having been processed, the finished goods may potentially sit in inventory for another month, potentially taking it to August; even if the crisis were solved immediately, the selling price at that future time in the third quarter would still have to reflect the input costs incurred today).

Inflation: looking for ghosts?

Inflation is rising. In the eurozone, the pre-war rate was recorded at 1.7% in January; the median average estimate for the bloc for 2026 is now 4%. The US Federal Reserve, the Bank of Japan and the Bank of England all opted to hold rates at their April policy meetings despite even the most recent rearward-looking data pointing to accelerating prices. The Bank of England pointed out in its statement that some of the companies it takes soundings from can see the inflation rate rising to 6% or even 7% before it starts to subside again. Even if the risks to interest rates are on the upside (and at the Bank, it was Huw Pill the chief economist who alone voted for an immediate quarter point rise), and whatever the misgivings among some members of their policy committees, the consensus or majority votes were to sit on their hands and do nothing for now.

For the UK, it is the risk of a fragile economy being further undermined by increased borrowing costs; in the US, outgoing Chairman Jerome Powell gave the impression that the jobs element of the Fed’s mandate is currently more important than maintaining inflation at 2% (and here, the Fed can always duck reality by claiming that its mandate is technically to focus on Core inflation which specifically excludes “volatile food and fuel prices” from its evaluation, as if US consumers don’t need to feed themselves or drive vehicles).

Investors think it’s real

If Trump and the Iranians are in a Mexican stand-off geo-strategically, in the prevailing monetary policy escalation the markets decided to bypass the formalities and to shoot first and ask questions later. With echoes of 2021/22 when policymakers were correctly assessed to have been asleep at the wheel, bond investors are already three steps ahead: while the central banks think that repetitive passivity is a virtue, markets reckon the authorities are eventually going to have to capitulate. Piling on the pressure they have jacked up the cost of government borrowing: UK 10 Year Gilt yields have nudged through 5%, their highest since 2008 (and 30 Year UK government bonds at 5.7% are back to where they were in January 1998); comparative 10 year yields of 4.4% in the US (note the 0.6 percentage point premium in the UK over the US despite our central bank interest rates being identical) and 3.1% in Germany are again very close to post-Global Financial Crisis highs. To be raising interest rates from here would be very different from similar action that was taken in 2022: then the starting point for interest rates was virtually zero in the aftermath of Covid; today we begin at 3.75% in both the UK and the US, and 2.0% in the eurozone.

Compounding errors: heed Ronald Reagan  

As if incipient inflation caused by the exogenous shock of the Gulf conflict is not enough, in the UK it comes on top of the wholly self-inflicted, completely avoidable car-crash unfolding before us in the business sector. As reported this week by the insolvency practitioner Begbies Traynor, 60,000 UK companies, many of which are in the hospitality sector, are in what Begbies describes as “critical distress on a financial cliff-edge”. That figure is a third higher than a year ago. Directly responsible are Rachel Reeves’ increases to employers’ National Insurance, her decision to raise the minimum wage and the big hike in business rates as the old Covid-reliefs are withdrawn.

It was Ronald Reagan who famously said, “the nine most dangerous words in the English language are, ‘I’m from the government and I’m here to help’”. All governments are struggling to cope with the economic fall-out of the Gulf blockade. As I discussed last week, many are introducing or contemplating rationing; approaching the problem from the other end, applying socialist policies from a centre-right government, Germany is introducing price controls limiting the frequency with which fuel retailers may raise their prices.

The UK government has also determined it is here to help. It has come up with a plan, two in fact, to contain the cost of living crisis. What can possibly go wrong.

Rent controls: red meat to the Left

Politically, private landlords are regarded as spawn of the devil. The populist view is they leech on society. Virtually all parties regard them as fair game with little political risk attached (indeed on the very day of this column’s publication new legislation comes into force to constrain the ability of landlords to evict tenants). Rachel Reeves’s reported plan is a centrally-imposed, mandatory, one-year national rent freeze, including the private sector, to help manage housing costs. Presumably designed to steal the Green Party’s thunder as Zack Polansky’s momentum threatens to eviscerate Labour, this is a neo-Marxist initiative pinched straight from the SNP/Green Coalition playbook in Scotland.

Such a policy would ignore the well-documented pitfalls of direct government intervention in the property sector and the unintended effects on both valuations and liquidity. Far from being an appropriate response to the oil crisis, as well as throwing red meat to the Left, in truth it would be simply an excuse to exert centralised control and for yet another ideological assault by the Labour Party on private capital. It would sit alongside Reeves’s determination to break the continuity of capital in passing on capital assets in the business and agricultural sectors. It would complement her establishment of the precedent of a wealth tax with her new graduated central exchequer surcharges to locally-levied council taxes for residential properties valued at more than £2 million, and the ability of councils to charge multiples of the base band rate of council tax where the property is not the owner’s primary residence. That she was forced mildly to dilute the inheritance tax proposal for the transfer of agricultural assets is no softening of the stance, that was merely a reaction to the political backlash from distressed farmers; she still fundamentally believes in the principle that taxing the transfer of business-related assets is correct.

Energy: when in a hole….

Closer to the nub of the energy crisis, Energy Secretary Ed Miliband is determined to help reduce the UK’s relatively expensive electricity charges where the underpinning of the pricing mechanism is directly linked to the price of gas. Given the big rise in renewable capacity where the cost of “fuel” (i.e. sunshine and wind) is free, it is a seductive argument. The early wind generating licences were offered on a contractual basis with that explicit link to gas. These are legally binding contracts which underpin the financial risk assumptions of the original capital investment; we can be sure that if turbine fleet owners agree to a review, there will be a price to pay; if the government effectively scraps the contracts unilaterally, no sensible developer will ever do business with us again.

But Miliband’s problem is one of his own making: by 2030 he is determined we will be entirely hydrocarbon-free domestically. We will generate 85% of our electricity from renewables which are innately variable and unreliable (to claim it’ll be “85%” when he has zero control over sunshine and wind and therefore how much will be generated in practice as a statement is self-evident nonsense). We still need a reliable base-load available instantly to meet demand for when the sun is not shining and the wind is not blowing. Nuclear is part of that, but the rest is reliant upon imports. Today, we regularly import almost a quarter of our daily requirement.

Electricity is a fungible, internationally traded product the price of which reflects the plethora of generating sources and their associated costs. Miliband is determined that we should join the EU’s electricity pooling scheme. Given we are nowhere near self-sufficient and are already importing vast amounts of electricity, the EU would have us over a barrel. We have less than zero leverage with which to negotiate terms. Renegotiating the original wind contracts does not solve the problem; it simply replaces one problem with another. As it is, through nationalised EDF, the French government owns most of our domestic nuclear generating fleet. We are deluded if we think we’re in the driving seat here.

Joining the dots on the subject of government intervention. In 2022, in response to the then energy crisis, the hapless Liz Truss implemented the energy price cap scheme. It was not a Tory initiative at all but one stolen from none other than Ed Miliband when he was Labour leader in 2015; to date it has cost the taxpayer £70 billion. Wiki tells me that the current projected capital cost of the new Sizewell C nuclear hall in Suffolk is £38 billion; we could have paid for two of those permanent-state power stations for the cost of an irrecoverable revenue expense to fix the price of gas and electricity temporarily. QED.  

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