Europe’s dependence on Russian energy

• One of the assumptions that Russian President Putin likely made prior to launching an invasion of Ukraine was that Europe would be reluctant to impose severe penalties on Russia due to its massive dependence on Russian energy. This turned out not to be true, but initially Europe was not keen on cutting off Russian energy. Rather, it participated in US-led sanctions on Russia’s financial system. 

However, things are changing. Indeed, things started to change even at the start of this crisis. Germany surprisingly agreed to halt certification of the Nord Stream 2 pipeline, leaving an US$11 billion undersea pipe sitting idle. The United Kingdom agreed to cut off Russian oil. Other European countries agreed to boost investment in the capacity to receive carbon-based fuels from sources other than Russia. 

Yet, the biggest shift was announced last week. After having dismissed the idea of reducing imports of Russian gas and oil, and having warned that such an action might lead to a European recession, Germany said it will wean itself from Russian oil and gas. Specifically, it said that it will reduce dependence on Russian gas by mid-2024 and become “virtually independent” of Russian oil by the end of this year. Meanwhile, the United States pledged to significantly boost shipments of liquid natural gas (LNG) to Europe this year, in line with other suppliers, thereby helping to wean Europe from Russian energy. The United States expects to increase exports of LNG by almost 70%. 

This is very significant given that Germany is the largest European purchaser of Russian energy. Meanwhile, the European Union is targeting a two-third reduction in European purchases of Russian gas. In addition, Germany is committed to building infrastructure needed to receive more imports of LNG. 

There are several potential implications if these plans bear fruit. First, reducing European dependence on Russian energy gives European countries greater flexibility in how they approach relations with Russia, including their amenability to further sanctions. Second, non-Russian suppliers of oil and gas will benefit from having greater opportunities to export to Europe. Third, Russia will lose a considerable amount of revenue, thereby worsening its ability to implement its military and foreign policies. These plans will likely be one more step on the road to almost completely isolating Russia from the global economy. Moreover, it will likely become irreversible. That is, financial sanctions can easily be reversed once Russia agrees to terms to which the West is amenable. But once energy production and trading patterns are shifted, they will become embedded in the system and Russia could permanently lose access to much of the European market. 

Putin announces payments in rubles

• Russian President Putin said that, going forward, Russia will invoice purchasers of natural gas in rubles. This will allow Putin to get revenue in a currency that will become more valuable. In fact, the ruble increased in value following his demand. 

Putin also said that “the collective West has killed all trust in their currencies.” For Putin, his order is likely meant to boost the attractiveness of rubles, thereby allowing Russia to buy more things using its rubles, especially to buy things from China and other countries that have not imposed sanctions. 

Meanwhile, the price of European natural gas increased sharply following Putin’s order. That reflects uncertainty as to what Putin’s order will entail in terms of the logistics of payment and what the European response will be. Even before Putin’s announcement, EU leaders were already considering restrictions on the importation of Russian oil. Thus, as noted above, the possibility of a sharp decline in European purchases of Russian oil and/or gas remains on the table. A study by the think tank Bruegel said that Europe can manage until late 2023 without Russian gas.

Bond market reversal

• Often in a crisis, investors seek the safety of the least-risky assets. This ordinarily leads to a sharp decline in bond yields. Indeed, immediately following the Russian invasion of Ukraine, bond yields fell sharply. Yet lately, bond yields have risen sharply. Are investors no longer worried about risk? Hardly. Rather, they are increasingly worried about inflation. 

As often discussed in these pages, the breakeven rate (the difference between the yield on a government bond and the yield on an inflation-protected government bond), which is a measure of bond investor expectations of inflation, has risen sharply in recent weeks. In the United States, the breakeven rate on the 10-year bond rose from 2.45% on February 22 to 2.92% yesterday. The yield on the five-year breakeven rose from 2.89% on February 22 to 3.57% yesterday. This means that investors believe US annual inflation will average 3.57% in the next five years, significantly above the Federal Reserve’s target but still much lower than the current rate of inflation. In any event, this large increase in inflation expectations more than fully explains the increase in headline bond yields. The yield on the 10-year bond increased from 1.95% on February 22 to 2.49% yesterday. 

Moreover, bond yields in other major economies have similarly increased sharply in recent weeks. This decline in bond prices (which are inversely related to bond yields) means that the bond market rout long predicted might finally be happening. For years, bond market pessimists have said that the end is near, that the 30-year long decline in bond yields is about to reverse. It never happened, until now. Even now, yields remain historically low. So, it might be too early to produce an epitaph for the bond market. Meanwhile, equity prices have rebounded sharply. Investors are evidently confident that the global economy will sustain healthy growth even in the face of enormous uncertainty.  

Inflation accelerates in Japan

• Inflation is accelerating in Japan and the authorities are concerned. Their concern is not just about inflation itself. Rather, they are concerned that rising commodity prices, which are a result of the war in Ukraine and are driving the acceleration in inflation, will reduce real incomes, thereby hurting economic growth. They are also concerned that the rise in commodity prices reflects potential shortages of key commodities, thereby putting production of some goods at risk. A Japanese government report stated that “as uncertainties around the situation in Ukraine loom, downside risks such as rising raw material prices, fluctuations in financial markets and supply constraints require full attention.” 

Japanese consumers prices were up 1.3% in March versus a year earlier, the highest rate of headline inflation since April 2019. This was fuelled, in part, by a 26.1% increase in energy prices, the highest in 41 years. When volatile food prices are excluded, core prices in Japan were up 0.8% from a year earlier, the highest rate since December 2019. When both food and energy prices are excluded, consumer prices were actually down 1% from a year earlier. Thus, the main inflationary problem for Japan is the sharp war-driven increase in oil prices. 

This energy disruption could not come at a worse time for Japan. The country suffered economic weakness throughout the pandemic due to government and voluntary restrictions on economic activity. While Japan was lucky to avoid a major outbreak, consumer spending was relatively stifled for much of the crisis. In recent months, however, things were starting to improve as the perception grew that the virus is under control. Now, yet another crisis is wreaking havoc with Japan’s economy. 

The Japanese government is keen to alleviate the negative economic consequences of higher energy prices. Thus, the government is considering providing financial relief to households. This is a policy under consideration in multiple countries and has been recommended by the OECD. Meanwhile, the Bank of Japan, having maintained a highly aggressive monetary policy aimed at boosting inflation, will likely reconsider its policy stance.  

Chinese supply chains disrupted by COVID-19

• While the world focuses on the supply chain disruption from the war in Ukraine, another disruption is taking place on the other side of the planet. The recent COVID-19 outbreak in China and Hong Kong has led to government-imposed restrictions. The result is considerable congestion at ports in Hong Kong and neighbouring Shenzhen, both hugely important to the global distribution of consumer and electronic goods. Congestion, in turn, is causing a spike in the cost of shipping goods and wreaking havoc with carefully planned logistics. 

This all stems from the recent sharp rise in the number of infections in China. Still, it should be noted that, although China’s infection rate hit the highest level since the pandemic began, it remains far below the levels seen in most other countries. And yet, China’s authorities are keen on suppressing transmission of the virus. Hence, the strict zero-tolerance policy and the decision to lock down cities that experience spikes in infections. This is what recently happened in Shenzhen, although restrictions there have been eased in recent days. 

Meanwhile, although the Port of Shanghai, one of the world’s busiest, continues to operate normally, observers are concerned by the sharp rise in infections in that city. The fear is that the government might lock down Shanghai, in which case the port will cease to operate while many factories will shut down—as happened in Shenzhen. Although the authorities deny plans to order a lockdown, the sharp rise in infections in Shanghai has already resulted in voluntary reductions in economic activity in this metropolitan area of 25 million people.

US inflation: the data, the debate, the policy response

• The US government recently released data on inflation for February. It was not favourable. Consumer prices were up 7.9% from a year earlier, the highest annual inflation in more than 40 years. Prices were up 0.8% from the previous month, the highest monthly increase since October 2021. The data was compiled before the war in Ukraine started. Thus, the February data does not incorporate the impact on global oil and food prices that stemmed from the war. That is, it seems likely that inflation data will worsen considerably in the months to come, if only because of the war. 

Even without the impact of the war, this report includes a massive increase in energy prices. The report says that gasoline prices were up 38% in February versus a year earlier and up 6.6% from January. Yet, when volatile food and energy prices are excluded, core prices were up a staggering 6.4% from a year earlier and up 0.5% from the previous month. This suggests that inflation is becoming more widespread, creating a bigger headache for the Federal Reserve as it attempts to gain control of the situation. 

On the other hand, the pattern of price increases remains similar to what has been seen in recent months. That is, goods prices are soaring while prices of services are not. Specifically, prices of durable goods were up 18.7% in February versus a year earlier, led by used car prices, which were up 41.2%. Prices of nondurable goods were up 10.7%. Yet, prices of nonenergy services were up only 4.4%. Thus, inflation continues to largely be a supply chain story, one that could worsen due to disruptions caused by the war in Ukraine. 

• The debate over inflation continues to evolve. A year ago, no one was talking about inflation in the United States or anywhere else. Six months ago, inflation was clearly accelerating, but the evidence was strong that it was driven by supply chain disruption, suggesting that a restoration of supply chain efficiency was all that was needed to reduce inflation. Two months ago, the conventional wisdom was rapidly shifting toward worry that inflation would be more prolonged and problematic than previously expected. The view was that inflation was becoming embedded in the expectations of businesses, workers, and consumers and that this would become self-fulfilling. That is why central banks, led by the Federal Reserve, were starting to tighten monetary policy. 
  

Now, with the war in Ukraine causing a severe increase in the prices of food, energy, and metals and exacerbating supply chain disruption, and with the renewed COVID-19 outbreak in China threatening to weaken global supply chains, there is growing angst about inflation. There is concern that the genie has been let out of the bottle and that suppressing inflationary pressure will now require a much more severe tightening of monetary policy, even at the risk of slowing or reversing economic recovery. 

The latter view was best explained recently by former US Treasury secretary Larry Summers. Summers wrote, “The Fed has not internalised the magnitude of its errors over the past year, is operating with an inappropriate and dangerous framework, and needs to take far stronger action to support price stability than appears likely.” Moreover, Summers said that recent events in Ukraine and China, alone, could increase annual inflation by 3 percentage points in the United States. Summers suggested that the Fed focus solely on inflation even if it means temporarily weakening the job market. He said that the Fed might have to boost its benchmark interest rate to 5% (keeping in mind that it is currently well under 1%). 

Nobel Laureate Paul Krugman, meanwhile, points out that, during past episodes of sharp increases in commodity prices, recessions came when the Fed response was harsh. Recessions did not come when the Fed remained relatively sanguine. He specifically notes how the two major recessions in the 1970s, which followed much sharper increases in oil prices than we are now experiencing, came about when the Federal Reserve tightened its policy sharply. He also notes that, when oil prices rose sharply in 2011 and the Fed stayed calm, a recession did not happen. Still, Krugman does not argue that the Fed should do nothing. According to him, given the surge in inflation, the Fed should remove monetary stimulus. However, he also said that the Fed should avoid “slamming on the brakes.” 

As for the Fed, last week it announced (to no one’s surprise) that it is boosting the benchmark interest rate by 25 basis points, the first such increase since 2018. This was, of course, widely expected. There was speculation that the Fed might engage in a 50-basis-point increase. The fact that this did not happen evidently pleased investors. Equity prices increased sharply following news of the Fed’s action. Fed Chair Powell said that this will be the first of many increases in the months ahead. The Fed adjusted its forecasts for growth and inflation. It downwardly revised its expectations for economic growth in 2022, in part due to the impact of rising commodity price stemming from the war in Ukraine. It upwardly revised its expectations for inflation. However, it continues to expect that, over the next two years, inflation will revert to a normal level. 

Specifically, the central forecast by the Fed’s leaders for the personal consumption expenditure deflator (PCE-deflator), which is the Fed’s favourite measure of inflation, is now for 4.3% inflation in 2022 (compared to a December forecast of 2.6%). In addition, it expects inflation of 2.7% in 2023 and 2.3% in 2024. It also expects that its benchmark interest rate will rise to 2.8% in 2023 and then stabilise. Overall, the Fed appears to retain the view that inflation has mostly been driven by temporary factors involving supply chain disruption. It’s upward revisions of inflation forecasts and downward predictions about economic growth largely reflect the impact of the war in Ukraine. The current policy of monetary tightening is meant to quell inflation while not sinking an economy that is facing a negative shock from the war. It will be a tough balancing act. 

• With the US Federal Reserve starting the process of tightening monetary policy, it appears that there is a growing confluence of monetary policies in many countries, with the Bank of England (BoE) and Taiwan’s central bank having boosted interest rates last week. In addition, the European Central Bank (ECB) signalled an end to asset purchases. The concurrent actions of many central banks are a response to the recent surge in global inflation. In addition, many central banks are averse to allowing the interest rate differential with the United States to rise sharply lest this leads to massive capital outflows and currency depreciation. Meanwhile, the war in Ukraine represents a challenge for central banks that must focus on both inflation and employment. 

For the third time since December, the BoE this week boosted its benchmark interest rate by 25 basis points, hitting 0.75%. This is the level last seen just prior to the start of the pandemic. The BoE has been the most aggressive of the world’s leading central banks in reacting to the surge in inflation. Yet, now it must contend with the war in Ukraine. The BoE said that the war will “accentuate both the peak in inflation and the adverse impact on activity by intensifying the squeeze on household incomes.” It also suggested that inflation could temporarily hit double digits due to the war. Despite this, it said that it intends to engage in further “modest tightening,” evidently being careful not to push the economy into a recession. It said that “the global economy outlook had deteriorated significantly following Russia’s invasion of Ukraine in late February, and the associated material increase in the prices of energy and raw material.” 

The ECB is taking a more cautious approach than the BoE or Federal Reserve. Perhaps this reflects the fact that inflation in the Eurozone remains lower than in the United States or the United Kingdom. Or, perhaps it reflects the fact that the Eurozone economy is far more vulnerable to the impact of the war in Ukraine than that of the United States or the United Kingdom. In any event, ECB president Christine Lagarde said this week that interest rate normalisation will not commence until at least several months after the ECB ends its asset-purchasing programme. The latter will happen soon. 

Finally, after the Federal Reserve boosted its benchmark interest rate by 25 basis points earlier this week, St. Louis Fed president James Bullard said the Fed should boost the rate to 3%. Bullard was the lone dissenter on the vote to raise the rate. He had wanted a 50-basis-point increase. Other Fed officials said that, while a 50-point increase might have been warranted in normal circumstances, the war in Ukraine warrants caution.  

China’s economy and the war in Ukraine

• China’s government issued relatively favourable economic data last week. As it normally does, it combined data from January and February in order to make consistent year-to-year comparison that would otherwise be distorted by the timing of the Lunar New Year holiday. The data shows that, in January and February, retail sales increased 6.7% from a year earlier, the best performances since July 2021. In addition, industrial production rebounded to grow 7.5% from a year earlier, the best performance since June 2021. And fixed asset investment was up 12.2% from a year earlier, the best performance since June 2021. 

This data might lead one to believe that all is well with China’s economy. Yet, that would likely be a mistake. The recent sharp decline in Chinese equities seems to reflect investor angst about a confluence of events that threaten to weaken the economic recovery. These include the fresh COVID-19 outbreak and the imposition of new economic restrictions (including a lockdown in Shenzhen), continuing weakness in the property sector, rising prices of imported commodities, potential disruption of global supply chains stemming from the war in Ukraine, and potential financial disruption from the tightening of monetary policy in the United States. As such, China’s vice premier Liu He said that the government will intervene to support the market economy, although he was not specific. He said he would take regulatory steps to ease stress in financial markets and would act to boost economic growth in the first quarter. Equity prices rebounded following his remarks. 

• It is increasingly evident that, despite statements that the Russia-China relationship is “stronger than an alliance,” China’s leadership is not willing to risk running afoul of Western sanctions. Consequently, Chinese economic interaction with Russia is rapidly declining, despite willingness to purchase more oil. For example, the Asian Infrastructure Investment Bank, a China-created vehicle for providing development assistance to emerging countries, said it will not provide loans to Russian entities. Many Chinese companies have cancelled shipments of products to Russia, likely due to fear of violating Western sanctions. Moreover, with the catastrophic depreciation of the Russian ruble, the ability of Russians to pay for imports has been reduced dramatically. 

Given that China’s economic relationship with Russia is relatively modest and that China’s economic relationship with Europe and North America is of almost existential importance, it is not surprising that China is unwilling to be more economically supportive of Russia.  

Why might China want to assist Russia? What might be in it for China? China’s leaders may see an interest in helping its Russian ally to avoid defeat at the hands of the West. If China helps Russia to attain victory, it could have a substantial claim on Russian resources in the future.   

The United States has said it will prevent China from shifting the situation on the ground. US National Security Advisor Jake Sullivan said that “we will ensure that neither China, nor anyone else, can compensate Russia” for its losses. He would not say how the United States will do this but said that details are being directly communicated to China. In addition, the presidents of the United States and China had a lengthy phone call in which these issues were reportedly discussed. 

What impact would Chinese military aid to Russia have on the global economic architecture of which China is a critical component? The impact would depend on how the United States and the European Union respond. The United States and Europe would likely respond to Chinese support for Russia with new sanctions on China. What if China were cut off from its reserves? While that is not likely to happen, it has become evident that this can be done, thereby giving China pause. And while China could avert trouble by encouraging greater global use of the renminbi, this would entail allowing convertibility of the renminbi, something that might invite destabilising capital outflows. So far, China has been unwilling to take this step, despite a stated intention to boost global use of the renminbi. China depends on a stable economic relationship with the United States and Europe. Its economic relationship with Russia is extremely modest in comparison. Thus, China has an economic incentive to avoid active involvement in this war.

Meanwhile, China likely aspires to be a much greater global power in the long term. Achieving this will not likely require involvement in Russia’s war. Rather, all China need to do is keep growing and, eventually, it will likely overtake the United States and gain greater geopolitical power. Why bother with a weak ally like Russia? Still, even if China overtakes the United States, it will not soon overtake an alliance of the United States, Canada, the United Kingdom, the European Union, and Japan. This is a formidable and powerful alliance with which China must engage for its economic success. 

Impact of the war on key industries

• During the past year, the semiconductor shortage wreaked havoc with many industries, none more so than the automotive industry. The shortage was driven by a surge in demand for information technology, especially as workers and shoppers shifted to remote interaction due to the pandemic. The shortage led to suppressed production of cars and other things, thereby fueling the inflation that has ripped through multiple economies. 

Now comes word that, at least until the war began, the semiconductor shortage was starting to abate—according to a survey conducted by Oxford Economics. Sadly, progress could be reversed because of the war. It is reported that semiconductor production capacity and utilisation have increased sharply in recent months. Unfilled orders from the automotive industry, while remaining high, have fallen. Also, the ratio of inventories to shipments in North Asia has increased, thereby removing some pressure on the industry. Going forward there are several trends that might help to reduce the shortage. These include declining consumer demand for goods, continuing increases in capacity (especially in South Korea), and a loosening of COVID-19 restrictions in some producing countries. 

Still, demand continues to exceed supply, thereby putting upward pressure on prices. And, although the industry is investing heavily in boosting capacity, much of that new capacity will not come online for several years. Moreover, the recent COVID-19 outbreak in China threatens to derail improvements in supply chain management.

Meanwhile, the war threatens to reverse recent progress. Several key inputs in semiconductor production are heavily produced in Russia and Ukraine, most notably neon. About 70% of global neon production takes place in Ukraine. On the other hand, chipmakers have been hoarding neon in anticipation of trouble. Thus, the impact of the war might not be immediately onerous. Still, the price of neon has already increased significantly. If neon distribution remains disrupted later this year after inventories are drawn down, then a more severe shortage could emerge. 

• The war in Ukraine also threatens to inflict significant problems on food distribution in many emerging countries, according to a report from the Conference Board. The report notes that Russia and Ukraine, together, account for about 6% of global grain production and about 16% of global grain exports. In addition, they produce a sizable share of the world’s fertiliser. The war could disrupt much of this. In Ukraine, crops might not be planted in sufficient numbers. And transport is already becoming problematic as shippers recoil from entering Russian and Ukrainian ports.

A sharp decline in Russian and Ukrainian production could render shortages and much higher prices in many emerging countries, especially in the Middle East and Central Asia. However, existing stockpiles in other countries, especially the United States, India, and the European Union, could be used to fill in the gaps. This could be critically important in maintaining social and political stability. Past experience tells us that significant surges in food prices have presaged social and political upheaval in several Middle Eastern countries.

Russian rouble collapses and financial system seizes up

• Following the decision by Western powers to sanction the Central Bank of Russia (CBR), the Russian rouble fell precipitously. In response, the CBR increased its benchmark interest rate from 9.5% to 20%. CBR governor Elvira Nabiullina said that “the central bank today increased its key rate to 20% as new sanctions triggered a significant deviation of the rouble rate and limited the central bank’s options to use its gold and foreign exchange reserves. We had to increase rates to compensate citizens for increased inflationary risks.” 

In addition, the CBR suspended equities trading on the Moscow Exchange after equities had already fallen sharply. The Russian government imposed capital controls, meaning that Russians may not send money abroad and cannot service foreign currency debts. Also, the government ordered Russian exporters to sell 80% of the foreign currency they have earned this year to help support the rouble. This could help to offset the shortage of foreign currency driven by the sanctioning of the central bank. S&P Global cut Russian sovereign debt to junk status.  

As for the financial sanctions, the restrictions placed on the CBR are the most impactful—at least in the short run. US Treasury secretary Yellen said that “the unprecedented action we are taking today will significantly limit Russia’s ability to use assets to finance its destabilising activities and target the funds Putin and his inner circle depend on to enable his invasion of Ukraine.” Prior to these sanctions, there was a widespread view that the CBR’s massive US$630 billion pool of reserves would protect Russia’s economy from other sanctions and enable it to fund the war as well as compensate for any loss of export revenue. This is now in doubt given that Russia will lack access to a sizable share of its reserves. Moreover, the act of sanctioning the CBR led Russians to attempt to liquidate bank deposits, thereby putting the entire banking system under stress, especially as the West has also sanctioned several major Russian banks and banned them from the Swift financial messaging system. On the other hand, the sanctions include a “carve-out” that enables energy-related transactions with the CBR. This is meant to avoid sharp swings in energy prices and allow oil and gas to keep flowing from Russia to the rest of the world.  

The global economic impact—so far

• Global investor fears are rising as evidenced by the sharp decline in bond yields since the war began. The yield on the US government’s 10-year bond fell sharply. The German government’s 10-year bond yield fell back into negative territory. There were also large reductions in bond yields for other countries including the United Kingdom, France, Italy, and Japan. In times of uncertainty and fear, investors often seek the safe haven of nonrisky assets such as bonds issued by stable governments that have strong central banks behind them. 

Meanwhile, even as bond yields have fallen sharply, the inflation expectations component of bond yields (the breakeven rate) has risen as investors fear that disruption of global energy markets will exacerbate and prolong inflation. Thus, real (inflation-adjusted) yields have fallen especially sharply. 

• Several shipping companies, including the world’s two largest (Maersk and MSC), are halting all cargo bookings to and from Russia, with shipments of food and medicine exempted. The shipping companies are concerned that they might run afoul of sanctions imposed by Western governments. This comes in addition to a UK decision to ban all Russian ships from British ports. In addition, European and Russian aircraft are banned from each other’s air space as are US and Russian aircraft and Japanese and Russian aircraft. The result is that planes travelling between Europe and Asia must take longer and more expensive routes. Japan’s two biggest airlines halted all flights from Japan to Europe. Not only is this disruptive to passenger travel, it also increases the cost and reduces the efficiency of transporting high-value merchandise in the underbelly of passenger planes. Plus, Russian cargo aircraft will be disrupted, likely reducing global capacity. 
• The price of oil soared since the war began. There have been no Western sanctions on the Russian energy sector. However, private sector players made decisions that led to a significant reduction in Russian oil shipments, thereby contributing to the rise in oil prices. Specifically, it was reported that refineries, banks, and shipping companies are reluctant to participate in the Russian oil market for fear of running afoul of sanctions on Russian banks. Thus, market participants are essentially engaging in self-sanctioning. 

In addition, it is reported that some shippers are avoiding transporting oil from ports in the Black Sea or Baltic Sea because they cannot obtain or will not pay for insurance against war-related damages. In fact, several commercial ships have been damaged from the war. The cost of shipping and the cost of insurance have risen sharply, changing the calculus for those active in the market. The result has been a sharp decline in activity in the market and a commensurate rise in prices. Russia’s ability to withstand sanctions rests, in part, on the continuing sale of oil and the resulting foreign currency revenue. 

Russia is the third largest oil producer in the world and, until recently, was exporting roughly 5 million barrels per day of crude as well as 2.7 million barrels of refined products. A significant disruption, if sustained, would change the trajectory of oil prices unless OPEC chooses to boost production. So far this has not happened. 

While there has been speculation that oil prices will rise higher as oil shipments from Russia are further disrupted, there is a plausible scenario in which, over the coming months, oil prices revert to where they were or go even lower. This scenario is based on the assumption that higher prices will generate increased production. That is, OPEC members could choose to produce more than their quotas. This has happened in the past. There will likely be more investment in capacity by shale producers in the United States (although the shale industry currently faces shortages of labour and key supplies). Moreover, if global demand decelerates slightly as a result of the war, then the net effect could be to suppress prices. In fact, a recent study by the Peterson Institute finds that, when petrostates go to war, there is an initial increase in oil prices, but it is usually not sustained over a longer period of time.  

Meanwhile, gas shipments through pipelines have not yet been disrupted. Gas is an especially important source of revenue for the Russian economy and government. Despite a lack of disruption, the price of gas sold in Europe has increased sharply, reflecting fears of imminent disruption, either because of sanctions, counter-sanctions, or the war itself. With Russia supplying about 40% of EU gas, the rise in price and the risk of disruption are creating serious concerns. Germany’s economy minister said that Germany must be prepared to utilise coal-fired power plants. Notably, the global price of coal has soared. 

• Some western companies that sell goods and services in Russia are exiting. Some Western goods will likely be replaced by goods from China or by domestic producers. In some instances, there will likely be shortages of consumer goods, and certainty much higher-priced goods. For Russian consumers, there will likely be a sizable loss of purchasing power and choice.  
• In discussing the potential global economic impact of the Russian invasion of Ukraine, some analysts are harking back to what happened in 1973–74. Yet, is this a valid comparison? At that time, following the start of the Arab-Israeli War, OPEC initiated an oil embargo to punish the United States for its military support for Israel. The price of oil quadrupled, inflation rose sharply in the West, central banks raised interest rates, and a significant global recession ensued. Moreover, price controls in some countries meant that retail prices of energy did not fully adjust, thereby causing a significant shortage. The United States witnessed long lines at gasoline stations. 

As of this writing, the price of oil is up roughly 25% from just prior to the invasion. Moreover, the real (inflation-adjusted) price of oil remains lower than a decade ago. Oil shipments have not been embargoed, but there has been a sizable decline in shipments of Russian oil as traders avoid interacting with their Russian suppliers. Yet shipments from the rest of the world continue. Thus, even a complete collapse of Russian shipments will not likely lead to the kind of catastrophic event seen nearly a half century ago. Moreover, following the 1970s’ crisis, businesses, households, and governments became much more efficient in their use of energy, compelled to do so by higher prices. 

Today, the world uses far less oil per dollar of real GDP than in the 1970s. Plus, we use a more diverse range of energy sources, and so we are not as reliant on oil. Thus, the economic impact of a given rise in the price of oil is far less today than in the 1970s. This is especially true for the United States where oil consumption is roughly equal to oil production. Thus, an increased price of oil in the United States is economically neutral, although the impact is negative for consumers while positive for energy producers. 

The war has led to a very sharp increase in the prices of many nonenergy commodities, especially food. Ukraine was always seen as the breadbasket of the old Soviet Union and is a major exporter of wheat and corn. Moreover, Ukraine and Russia together account for 30% of the world’s traded wheat. It is reported that trade in wheat has largely stopped, in part due to trader fears of running afoul of sanctions. There is fear that the war will cause a sustained disruption of trade in agricultural products. For lower-income countries, this could be devastating and could seriously exacerbate hunger. Also, Russia and Belarus are major exporters of fertiliser that is used for production of multiple crops. The prices of potash and phosphate have risen sharply. Thus, the global agricultural sector could be significantly affected by this war. Meanwhile, prices of neon and palladium rose sharply. Russia and Ukraine account for a large share of global production of these commodities that are heavily used by the information technology and automotive sectors. 

Recent favourable European data on retail sales, unemployment, and activity in services and manufacturing could be the calm before the storm. For much of the past year, commentary on Europe’s economy centered on the risk from new outbreaks of the virus. That risk remains but appears to be less on the minds of pundits and policymakers. Europe might have achieved a certain degree of herd immunity, thus rendering future outbreaks less impactful. Rather, the main risk now centers around the war in Ukraine. Already the European price of natural gas has risen about eightfold from a year earlier. In addition, oil prices are up sharply. These facts alone threaten to undermine recovery and exacerbate inflation, thus placing the European Central Bank (ECB) and the Bank of England (BoE) in a difficult position. If, going forward, there is further disruption of trade in energy, especially natural gas, Europe could face a significant deceleration in growth. After all, Russia accounts for 40% of EU gas imports, 25% of oil imports, and 47% of imported solid fuels. If there were to be a complete shutdown of Russian gas, there would likely be bottlenecks in several European countries, stemming from difficulties in distributing alternative sources of energy. 

US monetary policy and the crisis

What do recent events imply for the near-term direction of monetary policy? Futures markets indicate that many investors now expect a slight moderation in the pace of monetary policy tightening by the Federal Reserve, the BoE, and the ECB. That is, investors still expect the trajectory of benchmark interest rates to be up, but at a slightly slower place. Evidently, investors think that the crisis will have a negative impact on economic growth in the West, thereby implying less inflationary pressure. On the other hand, higher energy prices and more disruption to supply chains would imply higher inflation. Thus, for central banks, it will be a challenging balancing act. 

Federal Reserve chair Jerome Powell spoke last week about monetary policy in the wake of the war. Investors were eager to learn if the war would change the trajectory of monetary policy. Powell, however, suggested that not much has changed—at least not yet. With respect to the widely held expectation that the Fed will start raising interest rates this month, Powell said that “I’m inclined to propose and support a 25 basis point rate hike. The bottom line is that we will proceed, but we will proceed carefully as we learn more about the implications of the Ukraine war for the economy.” He added that “to the extent inflation comes in higher or is more persistent, then we would be prepared to move more aggressively by raising the federal funds rate by more than 25 basis points.” Thus, he left a degree of uncertainty as to whether there will be a 50 basis point hike as some pundits have predicted. 

Powell said that inflation is too high and that, unlike previously, it is not just a problem of goods prices. He said that service price inflation is too high and that the Fed is committed to bringing it down to a satisfactory level. He also said that he is not worried about the implications of multiple rate hikes for economic growth, saying that a soft landing remains possible. Still, he left open the possibility that monetary policy could curtail the rate of economic growth. Finally, with respect to the war in Ukraine, he said that the Fed will need to be “nimble,” recognising that the economic impact of the war will unfold in ways that cannot be predicted. 

Given the evident shift by Powell toward a more aggressive tightening of monetary policy, given the contraction of fiscal policy as the government borrows much less this year, and given the scope for disruption from the war, the preponderance of risk to the US economy appears to be on the negative side.

A very favourable US employment report is ignored by investors

• The US government released a stellar employment report for February. Everything went right. Job growth was strong, participation in the labour market increased, and the unemployment rate came down. Moreover, wage inflation decelerated. One couldn’t ask for a better report. However, investors mostly ignored the report as they were far more focused on events in Ukraine. Normally, an employment report like this one would have led to an increase in bond yields. Instead, the Russian attack on Europe’s largest nuclear power plant unnerved investors and others, and bond yields fell sharply in a clear flight to safety. Equity prices fell and oil prices surged. Here are some details about the employment reports:

The US government releases two reports: one based on a survey of establishments; the other based on a survey of households. The establishment survey found that 678,000 jobs were added in February, the highest number since July 2021. This left employment 2.1 million below the prepandemic level from exactly two years ago in February 2020, or 1.4% below the prepandemic peak. 

There was strong growth in many sectors. Construction employment was up 60,000, including a 24,300 increase for residential contractors. Manufacturing was up 36,000, despite an 18,000 decline in the automotive sector. Retail was up 36,900 as consumers returned to stores while omicron faded. There was an especially large increase of 12,100 for building materials stores, which served the needs of all those newly employed contractors. Transportation and warehousing were up 47,600 as people started to move about again. The financial services industry was up a stunning 35,000, with almost half that increase due to the real estate industry. Our own professional services industry was up 95,000. The education/health sector was up 112,000. Finally, the leisure and hospitality sector, which had accounted for the lion’s share of job growth in recent months, grew strongly but was responsible for a smaller share of the total. The industry produced 179,000 new jobs including 123,700 for restaurants and bars and 27,500 for hotels. 

The establishment survey also includes data on average hourly wages by industry. Notably, the average hourly wage for private sector workers was unchanged from January to February and up 5.1% from a year earlier. This was down from 5.5% in January and roughly similar to growth since October. In other words, wage inflation appears to have stabilised rather than accelerated in the past four months. This suggests that the shortage of labour might be abating due to an increase in participation and an increase in employment. Wages in manufacturing were up a modest 4.2% from a year earlier. Professional service wages were up 7.1%. In leisure and hospitality, wages continued to soar, rising 13.6% from a year earlier—although this was much less than in the previous month when wages were up more than 18%. 

The separate survey of households, which also includes self-employment, found that the working-age population rose 122,000 in February, participation in the labour market rose 304,000, and employment rose 548,000. The result was that the participation rate increased from 62.2% in January to 62.3% in February. The unemployment rate fell from 4% in January to 3.8% in February. This level is generally seen as full employment. The sharp rise in employment, therefore, reflects the entry of new people into the workforce. Evidently, many people who dropped out during the pandemic are coming back, increasingly confident that the virus is receding. This is helping to dampen wage increases and, therefore, avert a wage-price spiral that would exacerbate already-high inflation.

The West imposes new sanctions on Russia

• It is difficult to write about the war in Ukraine without the text quickly becoming obsolete. Last week, first after Russia placed troops in eastern provinces of Ukraine, and then after Russia invaded Ukraine, Western countries announced a series of sanctions on Russia. Initially, the United States, the United Kingdom, the European Union, and Canada imposed such sanctions as banning secondary trade in Russian government bonds, banning interaction with key Russian banks, banning exports of critical technology to Russia, and freezing the assets and banning travel for elite Russians. In addition, Germany halted the Nord Stream 2 gas pipeline.

Russia’s defense against sanctions was the revenue it continues to obtain through the sale of oil, gas, and other commodities; and massive foreign currency reserves worth US$630 billion held by its central bank. 

Given uncertainty as to how the war would unfold and what counter-sanctions Russia might initiate, financial markets reacted harshly to the invasion. Global equity prices fell sharply, especially prices on European exchanges. Bond yields fell, safe currencies (such as the US dollar and Japanese yen) rose in value, and the prices of oil and natural gas increased. The prices of other commodities that Russia and Ukraine export increased as well, including wheat and corn. Moreover, the Russian ruble and Russian equities fell sharply.

Then, over the weekend, the Western powers imposed more severe sanctions. Specifically, they sanctioned the Central Bank of Russia (CBR), thereby making it far more difficult for Russia’s central bank to obtain access to much of its foreign reserves. This was done by the United States, the United Kingdom, Germany, France, Italy, the European Commission, and Canada. Russia holds a sizable share of its foreign currency reserves in other countries. Much of its reserves are held in euros, pounds, and dollars, but some are held in gold and Chinese renminbi. If Russia cannot sell much of its reserves, it cannot defend against attacks on the ruble, thereby making the ruble vulnerable to collapse. Indeed, knowledge of this fact could generate a run on Russian banks.

Following the weekend decision by Western powers to sanction the CBR, the Russian ruble fell precipitously, dropping as much as 40% against the US dollar before bouncing back to a loss of about 28%. In response, the CBR increased its benchmark interest rate from 9.5% to 20%. CBR governor Elvira Nabiullina said that “the central bank today increased its key rate to 20% as new sanctions triggered a significant deviation of the ruble rate and limited the central bank’s options to use its gold and foreign exchange reserves. We had to increase rates to compensate citizens for increased inflationary risks.” 

In addition, the CBR suspended equities trading on the Moscow Exchange. The Russian government imposed capital controls, meaning that Russians may not send money abroad and cannot service foreign currency debts. Also, the government ordered Russian exporters to sell 80% of the foreign currency they have earned this year in order to help support the ruble. This might help to offset the shortage of foreign currency driven by the sanctioning of the central bank. S&P Global cut Russian sovereign debt to junk status.

The restrictions placed on the CBR are the most important. US Treasury secretary Yellen said that “the unprecedented action we are taking today will significantly limit Russia’s ability to use assets to finance its destabilising activities and target the funds Putin and his inner circle depend on to enable his invasion of Ukraine.” Prior to these sanctions, there was a widespread view that the CBR’s massive pool of foreign reserves (US$630 billion) would protect Russia’s economy from other sanctions and enable it to fund the war as well as compensate for any loss of export revenue. This is now in doubt given that Russia will lack access to a sizable share of its reserves. Moreover, the act of sanctioning the CBR led Russians to attempt to liquidate bank deposits, thereby putting the entire banking system under stress. On the other hand, the sanctions include a “carve-out” that enables energy-related transactions with the CBR. This is meant to avoid sharp swings in energy prices and allow oil and gas to keep flowing from Russia to the rest of the world. 

The other major action this past weekend was to limit the ability of several Russian banks to utilise SWIFT, a financial messaging system at the core of international trade and cross-border currency movements. CBR governor Nabiullina said that Russia has a system to replace SWIFT and that all obligations of Russian banks will be fulfilled. 

The latest on US consumer behaviour

• The omicron outbreak, which was especially severe in January, was expected to have a dampening effect on consumer activity in the United States. However, this does not appear to have been the case. Last week, the US government released data on personal income and consumer expenditures. It reveals that income fell, largely because of the withdrawal of government stimulus, and that spending continued to increase at a strong pace as consumers saved a smaller share of their income. Notably, spending on services was essentially flat as people avoided some forms of social interaction. Yet, spending on goods, especially durable goods, increased sharply—a major reversal from recent months. Thus, as omicron convinced some people to avoid restaurants and aeroplanes, many chose to spend more on goods for their homes. In addition, the latest report showed, not surprisingly, that inflation continued to accelerate in January. The war in Ukraine could exacerbate this situation. Here are the details:

Nominal personal income was mostly flat in January, with significant increases in wages offset by a sharp decline in government support as the child tax credit expired. In real (inflation-adjusted) terms, disposable income (after taxes) fell 0.5% from December to January. However, American households reduced personal savings from 8.2% of disposable income in December to 6.4% in January. The result was that spending increased significantly. Real (inflation-adjusted) spending was up 1.5% from December to January, the largest monthly increase since March 2021. However, real spending is only 4.5% higher than the prepandemic level from two years ago. 

The increase in spending was disproportionate due to the strength of spending on durable goods. Real spending on durables was up 8.5% from December to January, the biggest increase since March 2021. Real durables spending is now 24.6% above the prepandemic level of February 2020. That alone goes a long way in explaining the surge in goods prices. However, real spending on durables is now 7.3% below the peak reached in March 2021. This significant decline in spending on durables, if continued, bodes well for reducing inflationary pressure—especially if supply chain indicators improve. The decline suggests that pent-up demand has largely been sated, that many consumers feel comfortable going out again, and that a sharp rise in prices is inhibiting spending on goods. Still, the omicron outbreak appears to have interrupted the longer-term trend by boosting goods spending and suppressing spending on services. Indeed, real spending on services was up only 0.1% in January while spending on nondurable goods was up 1.9%. 

On the inflation front, the government released the Federal Reserve’s favorite measure of inflation, namely, the personal consumption expenditure deflator (PCE-deflator). The deflator was up 0.6% from December to January, roughly the same as in the past four months. The deflator was up 6.1% from a year earlier, the highest since February 1982. Notably, prices of durable goods were up 11.6%, nondurables up 7.2%, and services up 4.6%. This pattern is consistent with the view that inflation has been largely driven by the surge in demand for goods combined with supply chain constraints related to the pandemic. 

Going forward, the war in Ukraine has the potential to exacerbate inflationary pressure by boosting energy prices and disrupting supply chains for energy, food, and critical minerals. In addition, the Federal Reserve is especially worried that expectations of sustained inflation will drive a wage-price spiral. That is one reason the Fed is implementing a tightening of monetary policy. 

Europe’s economy rebounds in February

• It appears that the European economy rebounded reassuringly in February after suffering some negative consequences from the omicron outbreak. The latest Purchasing Managers’ Indices (PMIs) show a strong resurgence of services activity as omicron abates, thereby setting the stage for stronger growth in the months to come. The PMIs are forward-looking indicators meant to signal the direction of activity in the broad services and manufacturing sectors. They are based on subindices such as output, new orders, export orders, employment, pricing, pipelines, and sentiment. A reading above 50 indicates growing activity. Therefore, the higher the number, the faster the growth—and vice versa. The PMIs are compiled by IHS Markit, which just released flash (preliminary) PMIs for the Eurozone and the United Kingdom. 

The PMI for services in the Eurozone increased from 51.1 in January to 55.8 in February, a dramatic change and a level indicative of strong growth. Markit commented that “an easing of virus-fighting restrictions led to renewed demand for many consumer services, such as travel, tourism and recreation, and helped alleviate supply bottlenecks.” Meanwhile, the PMI for manufacturing was nearly unchanged at 58.4 in February, a level indicating extremely rapid growth. Markit noted that output accelerated due to improved supply availability. In addition, new orders grew rapidly, signalling strong underlying demand and confidence. Still, new order growth exceeded increases in output, leading to a surge in backlogs. This, combined with rising energy prices and rising wages, “added to inflationary pressures, resulting in the largest rise in selling prices yet recorded in a quarter of a century of survey data history.” Still, the report suggests that the Eurozone economy is rebounding nicely from the omicron crisis. 

The PMIs for the United Kingdom also suggest strength. The services PMI increased sharply from 54.1 in January to 60.8 in February, a level indicating very rapid growth. The manufacturing PMI remained unchanged at 57.3 in February, indicating continued rapid growth. The sharp rebound in the services PMI reflected a significant recovery of consumer spending on travel, leisure, and entertainment. Notably, Markit said that “production volumes in the manufacturing sector were helped by fewer raw material shortages and easing global supply chain pressures.” In addition, supplier delivery times improved significantly. 

Despite improvements in UK supply chains, the surge in demand was overwhelming, thereby leading to inflationary pressures. Markit commented that “higher wages, energy bills and raw material costs all contributed to rising operating expenses. The overall rate of input cost inflation was the steepest since last November and the second highest since the index began in January 1998. This resulted in another sharp increase in average prices charged by private sector firms.”  

Emerging markets and the difficulties they face 

Ian Stewart, chief economist of Deloitte North South Europe, provides an analysis of the challenges faced by emerging markets.

• On the face of it, emerging market (EM) economies have come through the pandemic in good shape. Activity in emerging economies held up better than in Europe and North America and the headline numbers suggest that the pandemic has taken a lesser toll than it did in many rich countries.

Scratch beneath the surface and a different story emerges. Outside China and Southeast Asia, the pandemic has hit many EMs hard. Data from the Economist shows that of the 33 nations with the highest excess deaths rates (deaths above normal levels relative to the size of the population), 30 are emerging economies. Among larger countries, Russia, Mexico, Poland, Hungary, and South Africa rank as having the highest excess death rates, roughly two to three times those seen in the United Kingdom. 

Nor has economic activity held up as well as the headline figures suggest. China’s zero-tolerance policy toward the spread of COVID-19 has helped suppress the virus and limit deaths, and consequently, China was one of the few sizeable economies that expanded in 2020. Most other EM economies shrank in 2020, with countries that have higher death rates tending to see the most severe downturns. Mexico and many emerging nations in south and central America and central and eastern Europe saw deep recessions.

EM economies tend to have more fragile public finances and find it harder, and more expensive, to borrow overseas than richer nations. Social security systems are less developed, making it more difficult to channel help to those most in need. Emerging nations spent at about a quarter of the rate of rich countries to support their economies in 2020–21. Because they were unable to subsidise wages and protect jobs on the scale seen in the West, emerging economies have suffered higher unemployment rates. The United Nations reports that the global “extreme poverty rate” rose for the first time in over 20 years in 2020.

The global economic recovery is continuing, but emerging nations face a long journey back to normality. More than two years into the pandemic, vaccination levels outside China and much of South America lag behind those in the West. Africa’s vaccination rate, at 12%, is boosted by South Africa’s relatively high rate of 29%; in most African countries, vaccination levels are a fraction of the 72% rate seen in the European Union. 

The inflation that is currently washing over the economies of the West is also hitting many emerging economies. (Asia is the exception, partly because lower case rates have resulted in less severe swings in supply and demand.) For most EMs, rising commodity prices, global supply disruptions, and higher import prices, triggered by weaker currencies, have stoked inflation.

After suffering job losses and reduced income due to the pandemic, many EM consumers now face rising prices and a further squeeze on spending power. Central banks in a number of EM economies, including Russia and Brazil, have had to raise interest rates in an effort to support their currencies and dampen inflation pressures.

With the US Federal Reserve about to start raising US rates, EM economies will have little choice but to keep raising rates. A US hiking cycle is also likely to put pressure on EM currencies, fueling inflation and raising the cost of servicing the large amount of EM debt-denominated in dollars.

So, it’s likely to get harder for many EMs to borrow overseas. Indeed, with government debt levels for most EMs up sharply since the start of the pandemic, debt reduction, reinforced by the pressure of rising rates, is the order of the day. This leaves EMs with less scope to boost their economies in the event of new COVID-19 outbreaks.

But what about China, the dominant EM nation, and the economy that has powered global growth for much of the last quarter of a century? The glory days of blistering double-digit Chinese growth are a thing of the past. China’s zero-tolerance COVID-19 policy and ensuing mobility restrictions are weighing on activity. Furthermore, the more transmissible nature of omicron poses a particular challenge to China’s zero-tolerance COVID-19 policy and to vaccines whose efficacy is lower than that of Western equivalents. Long-term factors are also at work. A shrinking workforce is slowing growth while elevated property prices and debt levels have created new vulnerabilities. Meanwhile, the government’s “common prosperity” programme designed to spread the benefits of growth more widely has brought new regulations that have wiped billions of dollars off the value of technology, education, and entertainment firms.

The baton for the fastest-growing emerging country has passed from China to India. Many forecasters see India growing by approximately 9% this year and outpacing Chinese growth for each of the next four years. Yet, even in India the pandemic has left a legacy of elevated youth and rural unemployment and weakened consumer spending power. Large though the Indian population and economy are, faster Indian growth cannot make up for slower growth in China, the world’s second largest economy.

Emerging economies played an outsized role in powering the world economy out of the financial crisis in the past. Between 2008 and 2015, for example, EMs accounted for almost 90% of the growth in nominal global GDP. The pandemic, however, has dealt EMs a hard blow. Nevertheless, the growth in EMs will continue to outpace that in developed market economies, but the gap between growth rates will be narrower than any time this century. The International Monetary Fund estimates that EMs will account for roughly half of the growth in world GDP between 2019 and 2026—hugely significant, but far less than in recent years.

The universe of nations that make up EMs is large and varied. So, too, are the circumstances of each country. Some EM economies suffered little lasting damage from the pandemic and are primed for good growth. Looking around the world, it remains the case that the fastest growth rates are to be found in EMs. But overall, and for most EM economies, the pandemic will cast a long shadow.

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