War and Sanctions Mean Higher Inflation

RUSSIA MAY tried to build a “fortress economy”, but it is the West that currently seems financially impervious. Compared to the deep economic crisis caused in the country by Western sanctions, the consequences for the rich world have been minimal. Although US stocks fell sharply when the war began on February 24, on March 2 they closed almost 4% above their level on the day before the invasion. European stocks are down around 4% – a big hit, but nothing compared to the ongoing financial rout in Russia, where the currency has crashed and stock trading has been suspended for days.

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The moderate reaction partly reflects Russia’s small weight in the global economy: around 2% in dollars. The country’s relative poverty and small population compared to the rest of Europe means that its exporters depend on European demand, but not the other way around. Goldman Sachs, a bank, estimates that the loss of exports caused by a 10% drop in Russian spending would only cost the eurozone about 0.1% of its GDP, and Britain even less so. Financial ties are modest.

Yet Russia’s economic importance far outweighs its GDP or financial through its energy exports. It produces almost a fifth of the world’s natural gas and more than a tenth of the world’s oil, the price of which determines much of the short-term variation in global inflation. In general, 30 to 40% of the EUGas supply comes from Russia (although it has fallen to around 20% in recent months as Europe has increased its imports by LNG of America). It not only heats European homes, but also powers much of its industrial production. Among the major economies, Italy and Germany are particularly exposed.

Energy prices rose dramatically on March 1 and 2. Spot natural gas prices in Europe have now more than doubled from their level at the start of February. The same is true for futures prices for delivery in December 2022, partly reflecting the cancellation of the Nord Stream 2 gas pipeline between Russia and Germany, which was hoped to ease supply this year. The price of oil rose more than 25% to around $115 a barrel. The energy crunch will make Europe’s inflation problem worse while hitting its growth. JPMorgan Chase, a bank, raised its inflation forecast for the euro zone at the end of the year by 1.1 percentage points, to 3.6%, while reducing its growth forecast for 2022 by 0, 6 percentage points, to 4.1%. As an oil and gas producer, America is mostly insulated from slowing growth, but will feel the inflationary effects of more expensive oil.

Things could get worse if sanctions expand to cover energy purchases or if Russia retaliates by cutting exports. JPMorgan Chase predicts that a prolonged Russian oil supply shutdown could push prices up to $150 a barrel, enough to send the global price down 1.6% GDP while increasing consumer prices by another 2%. The stagflationary shock would carry echoes of the 1973 Yom Kippur War, which triggered the first of two energy crises that decade. This greatly exacerbated an existing inflation problem caused in part by the collapse earlier that year of the Bretton Woods system of fixed exchange rates. Today, much more expensive energy would be superimposed on the inflation caused by the pandemic and the associated stimulus measures.

If oil and gas keep flowing, the existing increases in their respective prices will still make life uncomfortable for central banks, who were raising or about to raise interest rates anyway. They generally tolerate inflation caused by expensive energy. It tends to dissipate quickly or even reverse. But recently they fear that continued high inflation since last summer could lead businesses to think they should keep raising prices at a rapid pace and workers to keep demanding higher wages. Inflation, in other words, may have gained momentum. Further increases in energy prices can only aggravate this danger, while accentuating the compression of growth that higher interest rates entail.

Right now, markets are priced for a fairly conventional policy response. Since February 1, investors’ inflation expectations, revealed by the price of swaps, have risen sharply over a one-year horizon for Great Britain, America and the euro zone. Yet longer-term inflation expectations, as measured by long-term swaps, have not changed much (see chart). The projections of the ECBrate at the end of the year hardly changed. Investors have forecast a further quarter-percentage-point rise in interest rates this year in Britain and the United States. On March 2, Jerome Powell, Chairman of the Federal Reserve, indicated that it would raise rates further.

There have, however, been strong swings in bond yields at longer horizons. In mid-February, German five-year government bond yields were in positive territory for the first time since 2018. They have since fallen to around -0.25%. On March 1 and 2, the yield on a 10-year U.S. Treasury fell from nearly 2% to 1.7%, a bigger drop than in any two-day trading period since March 2020. , before recovering slightly to 1.9% the next day.

In other words, investors are betting that today’s inflation, even exacerbated by the war in Ukraine, will be temporary and that in the long run interest rates are likely to be somewhat lower than in the past screenings. But that doesn’t mean the markets are optimistic. In recent years, some researchers have argued that low real long-term interest rates partly reflect the impulse to hoard safe assets as tail risks – rare but very costly events – become more likely. After two years of pandemic and raging war in Europe, this thesis has never seemed so relevant.

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This article appeared in the Finance & Economics section of the print edition under the headline “The Global Economy at War”

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