The grim situation in Ukraine got materially worse last week. Targeted Russian air strikes on Ukrainian military sites were followed by a ground invasion with Russian troops reportedly surrounding Kyiv on Friday, while NATO allies bulked up their troop deployment along the NATO Ukrainian border. As a result of these tensions, the price of energy, wheat and various industrial commodities rose, while developed market equity indexes contracted, and the most asked question of the week (at least for economists) was, “How will central banks respond?”
While I don’t claim any particular ability to foretell Russian military or foreign policy actions, I can offer some thoughts on the economic effects of the crisis and how central banks will respond. Russia makes up only a small piece of aggregate global trade, accounting for 2% in 2020, down from roughly 3% in 2013, according to World Bank data. However, the situation is very different if we just look at Russia’s contribution to the global energy market. Putting it bluntly, Russia is an energy behemoth – it is the third-largest oil producer in the world and second-largest producer of natural gas. Europe is particularly dependent on Russian energy supplies, with one third of the natural gas it uses to heat homes and power its industrial production coming from Russia. It also gets more than one quarter of its oil imports from Russia.
Any disruptions to Russian energy trade could have significant economic implications across global markets, but most notably on Europe. However, at the time of this writing, energy trade hasn’t been disrupted, and the US had taken specific steps to ensure that Russian oil and natural gas continue to flow to the EU. For example, US economic sanctions on Russia’s largest banks specifically carved out money flows associated with energy trade, as long as the money went through a non-sanctioned, non-US bank (Adam Tooze of Columbia University has a great discussion of the sanctions’ energy carve outs here). It appears that the latest sanctions, which bar some Russian banks from using SWIFT, were implemented in a way that minimizes the impact on energy trade.
Although energy trade hasn’t yet been materially disrupted, the situation has raised the risk of such an event, and resulted in hoarding behavior that has driven up the price of energy, especially in Europe. Higher energy prices, which act like a tax on consumption and production, will impact real economic activity – particularly in countries that mainly import oil – as household real disposable incomes decline and business margins are squeezed. The global crude oil benchmark rose above $100 per barrel after media outlets reported on Russia’s invasion of Ukraine, while European natural gas prices rose around 50%. Meanwhile, the reaction in US natural gas markets has been limited by comparison as the US sources most of its energy domestically or from Canada.
Nevertheless, recent events come at a time of strong momentum in developed market growth, as economies recover from the pandemic, and fiscal stimulus is still offering some support. Prior to recent events we forecasted EU real GDP would grow 4% in 2022, while US GDP was expected to grow by a similar rate. Although higher energy prices will dent growth to varying degrees across the developed markets, absent an actual disruption in trade, we don’t think the recent energy price rise is enough to materially alter the outlook for moderating-yet-still-above-trend real GDP growth. And this, plus the inflationary tailwinds from higher commodities prices, coming at a time when central banks are already worried about rising inflation expectations, will likely keep central banks more or less on course to step away from the extraordinary policies put in place to combat the (much larger) economic disruptions from the global pandemic.
While a material shift in the current outlook for monetary policy normalization appears unlikely – at least for now – marginal differences in central bank reactions are possible, based on country specific factors. For example, the Bank of Canada may react somewhat more hawkishly as a result of the potential lift to Canadian energy exports due to higher global oil prices, while the ECB is likely to be more cautious as a result of (1) Europe’s higher dependence on Russian energy supplies, (2) its structurally lower inflationary trends – European inflation, while elevated, is still below its developed market peers with the exception of Japan – and (3) its generally more cautious approach to removing accommodation before this crisis. Finally, given the Federal Reserve’s general tendency to look through supply-side energy shocks and the US’s relative energy independence, we think the Fed’s reaction is likely to be somewhere in the middle. Indeed, we don’t think recent events will derail the Fed’s outlook for a series of rate hikes starting in March and a passive reduction on their balance sheet starting mid-year, although we don’t think it will speed it up either (i.e., a 50bp rate hike in March is likely no longer on the table for discussion).
What could stop central banks? Put simply, growing evidence that market stresses, which have so far been contained to Russian and Ukrainian asset markets, are starting to spill over into other areas – US and European credit and bank funding markets will be particularly important markets to watch. What could cause this more widespread stress? While it’s always difficult to pinpoint vulnerabilities ex ante, tougher Western sanctions, which do target energy trade, would likely have a much larger impact on markets. Meanwhile, Russian retaliation to Western sanctions through cyberattacks or trade disruptions are other potential catalysts for heightened market volatility. Finally, any of this could kick off banking sector stresses if US or European bank exposures are larger than widely reported. Indeed, while direct bank exposures to Russia are small, according to official statistics, Russia’s increased use of cryptocurrency, which make sanctions less effective, also makes it more difficult to track indirect financial linkages between it and the Western world, raising the risk of hidden problems.
What’s the Bottom Line? We don’t think these events will materially alter the relatively strong positions of Western economies coming out the global pandemic. Nevertheless, uncertainty around the outlook has risen, and central banks will have to weigh this uncertainty against fears that already elevated inflation will start to seep into longer-term inflation expectations. In the end, we think they remain on course, but unexpected market stress, or larger trade flow disruptions, would surely disrupt their efforts to normalize policy.
Unless explicitly stated, views expressed do not constitute official PIMCO views.