The devastating impact of the war in Ukraine has had profound economic repercussions. The spike in oil and gas prices triggered by the conflict (and the subsequent sanctions) has raised the threat of the worst stagflation shock since the 1970s. The Ukraine invasion will most likely give a second wind to inflationary dynamics which are already volatile in the post-pandemic recovery. However, high prices and deep political uncertainty should ease demand and help stabilise prices.
A combination of higher interest rates and quantitative tightening signals the end of this particular period of monetary accommodation. The fear of persistent high inflation has triggered a decisive shift in policy – the following seem insurmountable, but of course they aren’t:
- Short-term challenge of achieving a balanced level of global supply and demand.
- Longer-term challenges around global supply chains.
- A potential acceleration of the reorientation of globalisation.
Even if the outcome leads to a short recession, central banks should focus on the near-term inflation challenge and move ahead with overcoming the demand-supply imbalance.The longer-term challenges can only be overcome if the short-term high inflation period is dealt with first. The biggest change over the past few months has been the sudden shift in central bank priorities towards containing inflationary pressures through demand management, rather than focusing on ensuring that growth and employment are sustained.
The underlying message from policy-makers now seems to be that the pandemic-induced supply-demand imbalances have become entrenched and there is a threat that they could be more than just transient.
The key drivers of the imbalance are:
- Sustained strength of consumer demand
- Secondary commodity price shock triggered by the Ukraine crisis.
Could the central banks row back from their new stance?
The main catalysts for a shift would most likely be a sudden and substantial deceleration in economic activity or a sign that consumer demand could contract sharply in the near-term. Otherwise, policy-makers are likely to be wary of changing their bearish tone as both headline and core inflation rates are set to climb significantly from already elevated levels, which poses a greater risk than the short-term hit to consumer demand.
Our perspective
Our view was generally aligned with that of the Fed, that inflation would begin to ease this year, but this has proven to be misjudged as underlying pressures have continued to build. As central banks cannot change the supply of goods and services directly, they are clearly set to target demand.
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