Back-to-back inflation shocks
The global pandemic delivered a major shock to the global economy. Just as we were coming to terms with the shockwaves of this crisis, the Ukraine war dealt another major shock.
A key development from the first shock was inflation. Policymakers reassured us that this would be transitory. They changed their mind and decided that it would be more persistent and shifted policy direction.
The second shock adds further inflation pressure. At least in the near term. It has driven up commodity prices, but it will, in turn, crimp real income and reduce demand for all goods and services. It may add near term inflation pressure, but the longer-term consequences are harder to predict.
It creates a problem for policymakers – should they tighten just as they planned in response to the first shock, or should they tighten more gradually to support economic confidence? What will be the medium-term consequences for inflation?
Much may depend on how much the Ukraine crisis and the related commodity price shock crimps economic demand. It will be less imperative to raise rates if demand is sharply curtailed. Inflation may ebb more quickly beyond the next year.
However, there has been excess demand for labour. If the Ukraine crisis does not impact labour demand sufficiently, the spike in commodity prices may further add to inflation expectations and intensify wage pressures and medium-term inflation risks.
New Inflationary Era
A third slower wave may also be rolling over financial markets. The global pandemic arguably put some more power in this third wave. While we were all focussed on the transitory nature of the pandemic shock we didn’t realise we were riding on a bigger longer lasting wave – the transition to a low carbon economy and climate change mitigation. Perhaps because the wave has been building gradually, it has been less recognised as a significant factor in the global inflation outlook.
Globalisation was a long-lasting deflationary wave. The integration of China and other developing nations into the global economy kept driving down prices and allowed, even forced, central banks to stimulate demand to prevent deflation.
Some central bankers argued that these deflationary forces remain and will reassert their influence after the pandemic shockwaves have dissipated. However, they are likely to have passed their peak. Geopolitical risks have intensified markedly over recent years. Trump’s “American first” policy agenda, including a trade war with China, was perhaps a key marker in the shifting tide of globalisation. Geopolitical risks are now high on a rising wave and may reverse globalisation.
We are potentially moving into a long-lasting period of higher inflation. This period may be characterised by constrained supplies and unwelcome periods of weaker economic growth. Central banks and governments may be faced with a new conundrum of how much to tighten policy in the face of weaker than desired economic growth to dampen excessive inflation pressures.
Commodity demand is rising to address a shift in infrastructure towards more electrification and climate change mitigation. There will be more stranded assets and a need for higher investment that will help drive demand for commodities.
Factors of production will need to be allocated to address the impacts of more frequent natural disasters. Businesses and governments, no longer confident in global supply chains, will hold higher inventories and be willing to pay more for production inputs that are more resilient to climate and geopolitical risks. Consumers will be increasingly perturbed by the cost of living and demand higher wages. Skilled workers will tend to be in short supply.
The pandemic may be credited with opening our eyes to new possibilities and change. Just as we now see it is possible to work remotely, we can move faster to electrify the global economy. Rather than just a shock with waves that will pass, the pandemic is arguably a catalyst that has accelerated a bigger, more pervasive influence on the global economy.
Ukraine crisis may slow but not derail a global recovery
The Ukraine crisis is a supply shock that may cause some significant negative impacts on global demand in the near term. However, the global economy is on a recovery path from the pandemic and, as a result, may be more resilient.
The negative growth impacts are likely to be more apparent in Europe. Fear of supply disruption is greater in Europe. Fear of a wider conflict may further paralyse economic confidence. Travel in Europe is likely to be more severely disrupted.
We see this reflected in deeper falls in European assets prices and a quick reversal in ECB policy expectations, even as the latest Eurozone inflation data for February was again higher than expected.
The outlook for higher rates has diminished in the USA and other countries as well. However, it is less clear that central banks in other countries will delay policy tightening all that much. Indeed, they may eventually have to raise rates even further than expected and keep them higher over the medium term.
The impact of the Ukraine crisis on the global economy will be slower growth than otherwise. However, we do not see significant excess supply for goods and services or factors of production arising from this crisis outside of Europe. And perhaps not even in much of Europe.
The uncertainty around the Ukraine crisis is currently at a high level. It may rise further in the near term. Public opinion outside of Russia has been severely negative, and perhaps even in Russia. Cancel culture is in full swing against Russia. Government’s have been emboldened to go harder on sanctions.
There is an increasing risk that Putin will lash out as he gets backed into a corner. His first response is to intensify his offensive in Ukraine, ramping up pressure on Western countries to lend a hand. There is a real risk of NATO countries being drawn into a direct war with Russia, leading to truly terrifying global consequences.
We think the most likely scenario at this stage, albeit one within a still highly uncertain outlook, is that Russia will remain in a prolonged conflict within Ukraine. Suppose it does succeed in overcoming most of the Ukrianian military forces. In that case, it is still likely to face ongoing resistance and get bogged down in an economic quagmire both in Ukraine and Russia.
This will be a terrible result for Ukraine and leave Europe at an ongoing level of elevated uncertainty. However, the crisis may become just another disturbing uncertainty that we learn to live with. Economic activity may normalise for much of Europe, and investor confidence will improve from recent depressed levels.
The end game for Ukraine, Russia, and Putin is unlikely to be played out for years. There will be long-lasting consequences from Putin’s aggression. However, we expect the sense of crisis to ebb or at least become more normalised. We are shocked when we first feel the impact of a terrible event; we then learn to live with it and around it. As the year progresses, we believe central banks will need to keep a more watchful eye over inflation pressures that prove to be more persistent than expected.
Founder, Analyst, & PM
Amplifying Global FX Capital Pty Ltd
An Australian financial services company