Middle-East conflict to weaken Australian economy

23 June 2025

The escalating conflict in the Middle-East – specifically its implications for oil prices – could shave between 0.15% and 0.20% of GDP from the Australian economy this year, KPMG estimates, if the world oil market reacts in a similar way to how it responded to the first Iraq war in 1990-1991.

The monetary policy implications for Australia of such an oil shock – combined with the continuing threat of a global tariff fallout – would be likely be to push the RBA into a more aggressive rate-cutting approach, with potentially a further three 25 bp reductions to the cash rate this year, one more than KPMG’s original expectations at the start of this year.

The longer an oil price shock is sustained, the worse its impact is in terms of inflation outcomes, inflation expectations and short-term growth. This is because oil price shocks can be particularly damaging to an economy like Australia’s as the road transport sector – one of the heaviest users of oil in our economy – touches every single other sector (including itself) across the country. The pervasiveness of oil consumption in our modern economy means an oil price increase is akin to a reduction in the tax-free threshold for all taxpayers, as it reduces the remaining purchasing power available for households.

How long this Middle East conflict lasts and how deep it becomes is currently unknown. How the oil market reacts is also uncertain, but what we do know is that around 20% of the world’s oil supply comes from countries that border the Persian Gulf and who need to transport their oil on tankers through the Strait of Hormuz. For those with long memories the oil market responded to the 1990 Gulf war with a near 100% price spike over 6 months, up from US$17bbl at the commencement of the conflict in July 1990 to a peak of US$33bbl by Nov 1990, before dropping back to US$19bbl March 1991 as the conflict de-escalated.

Given this uncertainty it is reasonable to assume similar market adjustments today in trying to understand the implications of the escalating conflict on the Australian economy. This means assuming we will see impacts from the conflict lasting for around 9 months, with the world oil price doubling from around US$65 bbl today to US$130bbl between 2025Q3 and 2026Q1 – a level previously last seen in mid-2008 and close to being achieved in mid-2011, mid-2012 and mid-2022.

By our assumed end of the conflict (2026Q1) this higher oil price would shave global GDP growth about -0.1%, but Australia could be proportionately hit slightly harder given our higher dependence on oil.

How the RBA's role could impact Australia's GDP

The RBA will have a key role here. It could choose to ‘look through’ the temporary higher inflation, in which case GDP growth would fall by around 0.15% by early 2026, or if the RBA adopted a tighter stance on inflation and lifted the cash rate by between 0.25% and 0.50% our GDP growth would drop a bit more (-0.2%).

Even if the conflict de-escalates by the end of the March quarter 2026 the oil price shock is expected to continue to drag down the economy for a trailing quarter or two, resulting in marginal GDP losses peaking at between ~0.30% and ~0.40%, again depending on reaction taken by the RBA. Positively, however, our analysis shows that under either scenario Australian GDP would be expected to return to trend growth in about a year following the cessation of the oil price surge.

Remember that these new threats to GDP growth are on top of the anticipated economic hit from the impending changes to US Trade policy. Given current tariff proposals our separate analysis shows this policy change alone is likely to shave around 0.3% off GDP growth by late 2025 and into 2026, compared to a ‘no-tariff’ situation.

In summary, KPMG expects the RBA to look through any short-term inflationary impact of any oil shock, and combined with the fact that core inflation is now looking well entrenched in the target band and there is already an overall weakness in the Australian economy (especially the private side), we have revised down our cash rate forecasts for this year. Our expectation now is that the cash rate will end the year at 3.1%, rather than 3.35%.