The markets watch the revolution, cont.

By R.A. | WASHINGTON

AS THE day has worn on, it has become clear that the situation in Libya is not going to be resolved easily or without bloodshed. Muammar Qaddafi has vowed to fight to remain the leader of his country, and hundreds of Libyans have been reported killed. Meanwhile, protests continue to mount in Bahrain. The situation remains very uncertain.

Markets have continued to signal their concern. Equity indexes were down substantially around the world; American markets closed down around 2%. Perhaps more worryingly, American Treasury yields tumbled as a flight to safety resumed. Oil rose again; the price of crude is at its highest level since September of 2008.

This is not enough to do serious damage to the economy. An increase in oil prices of between $5 and $10, which is what we're talking about at the moment, will annoy American consumers, but it's not enough to drive the economy into recession. Most macroeconomic datapoints continue to indicate a strengthening American economy. Just today, we saw improved figures for consumer confidence and manufacturing, and a housing report that was better than might have been expected.

But policymakers need to keep a close eye on these events. Most large emerging markets are actively tightening policy right now. Europe is doing the same and will likely flirt with negative growth all year. It's easy to forget amid the headlines from the Middle East, but the euro zone debt crisis is far from resolved. Against this backdrop, continued bad news from Libya and neighbouring countries could begin to undermine growth expectations.

European crisis did just that last spring. Central banks failed to address this change in outlook quickly enough, and the rich world teetered on the brink of a double-dip for much of the summer (with a few exceptions, among them Germany and Britain). Only in the fall, when the Fed reacted to falling expectations with new easing, did conditions turn around.

The trouble this time is that while last year's slump coincided with a broad drop in prices, including those for commodities, a slump triggered by Middle Eastern unrest will likely be accompanied by rising oil costs. Given the circumstances, these will be broadly deflationary, but they may nonetheless make it difficult for central banks to respond to rockier conditions with new easing. We've already observed the criticism the Bank of England has faced for its policy stance, despite the fact that British inflation is largely due to increased commodity prices outside of the Bank's control. If central banks are hamstrung, there is little other support available to rich world economies. Europe is in full austerity mode, and America seems likely to follow.

Hopefully, for the sake of the global economy and the citizens of Libya, current fears won't amount to much. But rich world leaders need to be talking about what they're prepared to do if political stability undermines global recovery. You don't want to go into a tough situation without a plan.