While the global market has not yet had time to fully recover from the shock of the pandemic, the long-overdue Ukrainian-Russian conflict has broken out, leading to military action. Let’s try to understand how this may affect economic growth, inflation and monetary policy in the world, writes Bloomberg.
The military operation followed weeks of tensions that caused turmoil in the global economy, and in particular, sent energy prices soaring. Events accelerated on Thursday, February 24, when the price of Brent crude briefly rose above $100 a barrel for the first time since 2014, while the price of European natural gas jumped 62%.
Meanwhile, Western governments are taking steps to punish Russia, while realizing that by doing so they could exacerbate the impact of the conflict on their economies as well.
U.S. President Joe Biden, who on Thursday announced new sanctions targeting Russian banks and their ability to trade in dollars, did not fail to mention that there will be a price to pay: in the U.S., significantly higher gasoline prices are already eroding his support among voters.
The legacy left in the world, and in the West in particular, by the pandemic – 2 key vulnerable points – high inflation and financial market instability, is these days accompanied by the “aftershocks” of the events in Ukraine, which could easily worsen both. Falling markets create another headwind: hitting wealth and business confidence and making it harder for firms to raise funds for investment.
Central banks have their own problems, on a larger scale – managing the price trajectory and keeping the economy growing. Now the U.S. Federal Reserve and the European Central Bank, which have been willing to tighten their monetary policies, may have a lot to rethink.
How severe the blow to the global economy will depend on the duration and scale of the conflict, the severity of Western sanctions and the likelihood of a retaliatory strike by Russia. Right now, however, there is a surge in household spending, with households having to spend an increasing proportion of their income on fuel and heating, leaving them with less money for more expensive food and services.
Bloomberg Economics has compiled 3 scenarios that examine the impact of military conflict on global economic growth, inflation and monetary policy.
In the most favorable development of events – a quick cessation of hostilities prevents further spiral development of inflation in the commodity market, supports economic recovery in the U.S. and Europe, so that central banks will have to make adjustments to their plans, not abandon them. That is, there will be no disruptions in oil and gas supplies, and energy prices will stabilize at current levels. Financial conditions are tightening, but without a sustained market downturn. Such optimism and belief in a good outcome of the conflict was inspired by the Western countries’ sanctions against Russia, which, according to the US President, “exceed everything that has ever been done”: they include fines against 5 banks of the country, including the largest one – Sberbank, and the introduction of export controls, which will limit Russia’s access to high-tech products, and personal sanctions against the elite. Russian energy supplies have not been affected, which has somewhat stabilized oil prices. The main advantage in this is for Europe itself, as Russia is its main supplier of oil and gas. The euro bloc itself is likely to avoid recession, and the December ECB rate hike will remain in effect.
A slightly more negative scenario is a protracted conflict, consequently causing harsher Western sanctions against Russia and disruptions to oil and gas exports, hence an even bigger shock to the energy sector and a severe blow to the global market, which would quite likely rule out an ECB rate hike this year and slow down Fed policy tightening. An energy supply disruption, caused by some oil tanker owners avoiding taking Russian oil until there is more clarity on sanctions, or possible damage to gas pipelines running through Ukraine during the fighting, would cause a shock to energy prices. As a consequence – gas prices will return to 180 euros per megawatt hour and oil to $120 per barrel, inflation in the eurozone will approach 4% by the end of the year, which will intensify the decline in real incomes and deal a significant blow to GDP. The ECB will have to forget about raising rates until 2023.
For the US, whose economy is linked to Europe’s, such a scenario could boost overall inflation to 9% in March and keep it near 6% by year-end. Further financial turmoil and a weakening economy, partly due to the economic slowdown in Europe, would cause the Fed to focus on risks to growth.
Finally, in the worst-case scenario, everyone will suffer: both Russia, due to Western sanctions, and Europe, which will not wait for gas supplies, triggering a recession in the European economy, while in the U.S. financial conditions will become much tighter, economic growth will slow, and the Fed will have to hang on to its hawkish policy, which will take a markedly more dovish course. Faced with such a Western sanction as exclusion from the Swift international banking messaging system, Russia could easily retaliate by cutting off gas supplies to Europe. EU officials didn’t even think about that last year when they were modeling 19 scenarios for stress-testing the bloc’s energy security. Specifically for Europe, cutting gas supplies by even 10% could reduce eurozone GDP by 0.7%, and if the figure is raised to 40%, GDP would lose 3%. The actual loss could be even higher, given the chaos such an unprecedented energy crisis would cause. This means recession and no ECB rate hike for the foreseeable future.
For the U.S., such a scenario would also do no good: the U.S. economy would experience the unintended consequences of maximum sanctions that would undermine the global financial system with secondary effects on U.S. banks. The Fed’s entire focus will shift to preserving growth. If higher prices lead to entrenching inflationary expectations among consumers and businesses, this will necessitate very tight monetary policy tightening in a weak economy.
Some countries, such as Saudi Arabia and other Gulf oil exporters, may benefit, but for most developing countries, whose recovery from the pandemic has been slower, the combination of higher prices and capital outflows could deal a severe blow and exacerbate risk.