EY's chief economist, Greg Daco, has warned that in the most extreme scenario of an uncontained Israel-Hamas conflict, oil prices could surge significantly, potentially reaching triple-digit figures, and market volatility could experience a sharp increase.

Daco outlined three potential scenarios for the ongoing Middle East conflict. Despite concerns of a broader regional conflict, financial markets have, thus far, responded with relative calm.

The most severe scenario Daco presented is an "uncontained scenario," in which the conflict escalates and could draw the involvement of the United States and/or Iran. In such a situation, oil prices might immediately spike by $50 per barrel, reaching $150 per barrel by late 2023. Simultaneously, the VIX, a measure of market volatility often referred to as the stock market's fear gauge, could experience a substantial surge, potentially increasing by at least 18 points.

Daco anticipates that these effects would gradually subside in the following year. He predicts that oil prices might return to a level just $10 above the baseline forecast in 2024, with market volatility easing to just four basis points above the baseline forecast.

Nonetheless, Daco underscores that such a scenario, even if brief, could have significant repercussions for the global economy. Potential consequences include a mild global recession, a 1.4% drop in global real GDP growth through the end of the next year, and a global economic value reduction of approximately $2 trillion.

Financial conditions would likely tighten as well, with the possibility of stock markets declining by as much as 20% and the U.S. dollar strengthening by 10%. Furthermore, global inflation could experience an increase of 1.5 percentage points beyond EY's baseline 2024 forecast due to higher energy prices. "This scenario would pose a significant challenge for central bankers as they grapple with an inflationary shock, occurring at a time when inflation remains well above official targets," Daco noted.

Nevertheless, Daco anticipates that the severe tightening of financial conditions and global economic recession would likely prompt major central banks, including the Federal Reserve, European Central Bank, and Bank of England, to ease their policies more rapidly than in the baseline scenario in early 2024. However, he does not expect them to reduce interest rates to zero, as they might have in previous crises. By the end of 2024, a "higher-for-longer" approach would likely prevail once more, with central bankers opting for a slower pace of policy easing.

Financial markets currently anticipate the Federal Reserve maintaining higher interest rates, as central bankers maintain a hawkish stance on inflation. Investors are pricing in a 98% likelihood of rates remaining above 4% by the end of the next year, as indicated by the CME FedWatch tool.

In other scenarios related to the Israel-Hamas conflict, there remains a possibility of a minor uptick in oil prices and short-term market volatility. In the best-case scenario, oil prices would increase by just $3 per barrel, while the VIX would rise by a single basis point above the initial forecast over the next six months. This is followed by a second-best scenario, where oil prices would initially rise by $7 per barrel before gradually returning to a level $3 higher than the baseline price forecast. Simultaneously, the VIX would experience a five-point increase by late 2023 before stabilizing at just one basis point above the baseline forecast by the end of the following year.