Macroeconomic & Geopolitical

Is Russia's Invasion Inflationary or Deflationary?

March 2022 – 3 min read

Prices are headed higher for now, but this time they will have their own moderating impact on demand.

Global tragedies, the COVID-19 pandemic, and the Ukraine invasion delivered similar economic shocks, roiling the balances of supply and demand. But the lockdowns came with floods of cheap money and generous subsidies, while this war coincides with central banks tightening and governments thinking harder about deficits.

Inflation will clearly be much higher for much longer, but it still looks … impermanent.

Even if supply remains tight for a while, demand will weaken and restore balance. Rising rates are already starting to cool business sentiment, and higher grocery and fuel bills will temper consumer enthusiasm. By the end of the year, as prices stabilize at higher levels, hawkish central bank statements will moderate into what doctors call “watchful waiting” so that their powerful medicines don’t wind up doing more harm than good.

In Europe, where growth is low and the impact of the war is high, it may be very hard to avoid a recession. America’s recovery has been much stronger. Markets may be volatile as interest rates edge higher and profits stumble, but it’s hard to imagine growth actually turning negative for now.

As a rule, wars disrupt supply chains, trigger more spending, and drive up prices for key commodities that are suddenly in urgent demand. Inflationary dynamics that were already worrying in the post-pandemic recovery are clearly getting a second wind. Any lingering hopes that the U.S. Consumer Price Index might fall back below 2% by early next year are gone.

The temptation is to latch on to the latest reports of negotiations between Moscow and Kyiv and hope for a cease-fire that will end the humanitarian nightmare and restore stability to markets. Maybe the current winter wheat crop can reach the market. Maybe the demands to cut off all Russian oil and gas purchases will fade and allow prices to stabilize.

But with Vladimir Putin still unable to topple Volodymyr Zelensky, and with Ukrainians resolutely committed to defending their country, no potential deal looks lasting at this stage. More important, no outcome short of a Russian defeat and apology (and reparations) seems likely to loosen the sanctions on Russian financial flows that have done so much to disrupt global supplies. Even then, the broader effort to diversify away from Russian suppliers will continue. It may take years to rebalance supply and demand.

For now, oil prices will edge higher, already up 50% so far this year. Wheat is still 40% higher and aluminum is up 30%. These were tight markets before February, and prices will likely swing sharply as the effects of lost Russian and Ukrainian supplies work their way through global markets.



What is also likely, however, is that these high prices and the deep political uncertainty that comes with them will chip away at demand. The PMI readings Thursday still show strong consumer sentiment in the U.S. as COVID-19 restrictions eased. But business confidence also reached a five-month low as the end of the recovery surge comes into view. In Europe, readings in both services and manufacturing edged lower, but remain in expansion. New orders fell for the first time in 21 months.

Even the most resilient consumer has limits. This year’s summer surge will pale in comparison to last year’s. Higher prices on key consumer goods, including gasoline and food, dampen optimism and tilt decisions from spending to saving.

Moreover, after two years of running up large debts for pandemic relief, at least the U.S. government is decidedly not in a mood to soften the blow with a fresh round of handouts. True, we will see more general support across Europe and more defense spending everywhere, but that may take time to alter the course of this business cycle.

In some ways, it’s just a normal pattern of economic upswings and downswings, but the sharp shifts in prices will make it look like “stagflation” with higher prices and slowing growth.

The confirmation will come over the next couple of earnings seasons as companies that have so far easily passed their higher costs on to consumers start to report shrinking profit margins. Savings rates should start to rise, too, as consumers worry about a job market that won’t be quite so tight.

So, is war inflationary or deflationary? The answer for now seems to be: yes.

Christopher Smart, PhD, CFA

Chief Global Strategist & Head of the Barings Investment Institute

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