Europe: How the war in Ukraine will fuel a sharp hike in inflation
By Sourced Externally
February 27, 2022
Economists are warning Russia’s invasion of Ukraine will fuel a sharper rise in inflation, despite the rising cost of living having already hit the highest levels for three decades.
With Russia the world’s biggest natural gas exporter and second-largest for oil, the stakes are high in a global economy still hooked on fossil fuels – drawing parallels with the Yom Kippur war and oil price shocks of the 1970s which led to galloping inflation and economic crises worldwide.
Michael Strobaek, global chief investment officer at Credit Suisse, said the shock waves emanating from the Russian invasion amounted to the “dawn of a new world order” for the international economy, in which higher inflation and financial market volatility could be taken as given.
“Russia’s invasion of Ukraine marks nothing less than a shift away from the largely US/western-dominated world order that has prevailed since the fall of the Berlin Wall,” he said.
There are several channels through which an inflationary shock will ripple around the world:
European natural gas prices surged by almost 70% after the invasion of Ukraine, while the global oil price touched $105 for the first time since 2014. Although prices fell back on Friday, they remain historically high – fuelling the prospect for a further rise in living costs.
Some countries are worse affected than others. Across the EU, Russian gas accounts for 40% of the energy supply, although in some nations such as the Czech Republic and Latvia it rises to 100%.
Germany has become more dependent on external sources of energy in the past two decades, rising to 67% – among the highest rates in the EU – as it scales back nuclear energy production. In terms of gas supplied from Russia, the country accounts for 65% of total natural gas imports in Germany, worth £52bn in 2020, according to Eurostat. France, which has a higher share of nuclear power, relies on imports for less than half of its energy by comparison.
Russian gas accounts for little of the UK’s energy mix, at just 5% of total imports last year. However, the surge in global prices will still damage living standards in the UK at a time when consumers are already preparing for household gas and electricity bills to rise by 54% from April.
UK inflation was expected to rise from the current 30-year high of 5.5% to a peak of more than 7% in April. Assuming a drop in wholesale energy costs and the government’s £200 repayable loan for households, inflation was expected to drop later this year.
However, should the recent surge in prices be sustained, experts believe inflation would not peak at a higher rate in the short term, although would be likely to remain persistently higher for longer than first thought.
City economists still believe gas exports will continue flowing, echoing the history of east-west tensions during the cold war when the Soviet Union continued pumping oil and gas to Europe. With Russia raking in $700m (£523m) each day selling oil and other commodities to the west, Putin has a strong interest in maintaining the flow, while the west has a strong interest in buying to avoid exacerbating the worst inflation shock for decades.
Wheat prices have jumped to the highest level since 2008, threatening to push up food prices. Decades earlier the Soviet Union was the world’s biggest importer of wheat, with a record 55m tonnes bought in the mid-1980s. However, Russia overtook the US and Canada to become the world’s biggest exporter in the middle of the last decade. Ukraine – nicknamed the bread basket of Europe for its vast, fertile fields – is the fifth largest.
Developing nations in north Africa and the Middle East are among the biggest buyers, meaning that a trade shock would devastate poor countries. Figures from the Observatory for Economic Complexity show in 2019 Egypt, Turkey and Bangladesh bought more than half of Russia’s wheat. Almost 85% of Egypt’s imports last year were from Russia and Ukraine.
Although soaring energy prices will provide the biggest source of inflationary pressure, fresh disruption to trade routes will add to costs and delivery times for companies – factors which have also contributed to higher consumer prices.
Motorists, who have already had to pay record high petrol and diesel prices at UK pumps this year, are likely to see the direct, immediate pain. The RAC said a litre of unleaded touched an average 149.7p this week, with diesel at £1.53, but more increases were on the way with oil hitting $106 a barrel, as well as the pound weakening.
Airlines have traditionally sunk or swum on the jet fuel price, with the highs of a decade ago tormenting an industry which had pared other costs back in offering low-cost fares.
This specific conflict could have a particular impact on the shipping industry, which has already been buffeted by the container shortages, Covid and the blockage of the Suez canal. According to the International Chamber of Shipping, almost 15% of the world’s seafarers are Russian or Ukrainian, and supply chains and costs could be affected if the free movement of such a significant part of the labour force is restricted.
Economists expect the conflict will complicate decisions for global central banks to raise interest rates, with some analysts expecting they may push back planned hikes despite the situation adding to inflationary pressures.
Meanwhile, there is still hope in the City of London that the crisis can be contained, reflected in a stock market rally on Friday after selling off sharply earlier in the week.
Economists at UBS argue that financial conditions remain supportive for growth, despite expectations for an increase in borrowing costs. “Market expectations are for [Federal Reserve] policy rates to peak only at about 2% – this is hardly a ‘Volcker shock’, when the Fed hiked rates to 20% to subdue inflation,” said Mark Haefele, chief investment officer at UBS global wealth management.
The consequences of a further squeeze on real incomes from an energy-fuelled inflation shock will mean higher rates of unemployment and lower global economic growth, at a time when the world economy is still grappling with the fallout from Covid-19.
Even before the invasion the Bank of England forecast that higher rates of inflation and rising interest rates would bog down the recovery from Covid, with forecasts for a rise in unemployment and weaker rates of GDP growth next year.
Goldman Sachs said financial markets were now pricing in the likelihood of global growth being 0.5 percentage points weaker this year than first expected due to the conflict, as rising energy prices depress production and squeeze consumption.
Analysts said the Bank faced a dilemma over how to react. The central bank was widely expected to raise interest rates at regular intervals this year to curb soaring inflation. However, it may need to either go further or hold steady. While the conflict is expected to add to inflation by driving up global energy prices, the additional squeeze on household incomes is likely to slow the UK economy.