Vladimir Putin

Vladimir Putin

The Fed was also planning to begin withdrawing some of the liquidity it had pumped into the US financial system through its massive bond and mortgage purchases in response to the pandemic and the ECB had a similar eventual exit on its horizon.

Then Russia invaded Ukraine and drew,this week,an extraordinary range of sanctions. These included sanctions on its vast foreign exchange reserves but,notably,excluded measures that might directly impact the exports of oil and gas on which Europe is very reliant and which provided the core of Russian government revenues.

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Those sanctions caused immediate havoc within Russia – the rouble’s value plummeted,its stock market was shut,there are bank runs and likely collapses/bailouts,the Bank of Russia’s policy rate more than doubled from 9.5 per cent to 20 per cent and the prospect of recession became very real.

While there haven’t been the same crisis-like events outside Russia,the flow-on effects of the invasion and the sanctions are showing up in financial markets. Most notably,despite the exclusions in the sanctions for Russia’s energy exports,the oil price soared on Tuesday,jumping $US8.99 a barrel to $US107.41,its highest price since 2014. Pre-invasion oil was trading around $US92 a barrel after starting this year at just under $US78 a barrel.

Key agricultural commodity prices – wheat,corn and soybean prices – also spiked to their highest level in the best part of a decade. Metals prices,including aluminium and nickel,rose sharply.
The sanctions are also having an impact on global shipping as companies scramble to ensure they comply with the sanctions.

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The world’s largest shipping companies have suspended shipments to and from Russia as they try to work through the implications of the financial sanctions and export controls the West has imposed. That’s adding a new layer of disruption and costs to global supply chains that were only just beginning to recover from the pandemic.

The war is likely to further hit shipping and supply chain shortages.

The war is likely to further hit shipping and supply chain shortages.Credit:Getty Images

The oil price soared despite oil’s exclusion from the sanctions. Companies and traders are concerned about the impact on Russian banks and companies’ stability,whether the financing/trading of oil might be inadvertently caught up in the sanctions and,most significantly,whether Russia either weaponises its energy exports and cuts off supply to Europe or the West accepts the self-harm and sanctions Russian energy to hit Russia where it hurts most.

Before the invasion central banks were being challenged by the highest inflation rates in 40 years against the backdrop of surprisingly strong economic rebounds from the pandemic – rebounds powered by the extraordinary fiscal and monetary response to the outbreak of COVID-19.

In the US as many as seven 25 basis point increases in the federal funds rate this year were priced into the US bond market and the Fed was expected to start shrinking its balance sheet by not replacing some of the $US5 trillion ($6.9 trillion) or so of assets it purchased during the pandemic as they mature.

The ECB was expected to raise rates twice towards the end of the year,shifting its policy rate from minus 0.5 per cent to zero.

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Those expectations have changed. At least two of the Fed rate rises have now disappeared from market calculations and trading in European government bonds is signaling minimal,if any,change to ECB rates.

In the US bond yields that were rising quite sharply have fallen abruptly,with the yields on both two-year notes and 10-year bonds slumping by around 30 basis points within the past week. In Germany,the yield on 10-year bunds,which had pushed into positive territory in January for the first time in three years,has dropped back below zero in the past few days.

Conventionally,given the degree of disruption and range of uncertainties occurring within the global financial system and economy because of the sanctions,the Fed and ECB would hose their markets with liquidity to ensure there are no unintended consequences within the plumbing of their financial systems.

The extent of inflation within their economies – 7.5 per cent in the US and 5.6 per cent in Europe – handcuffs them. More ultra-cheap liquidity would only fuel more inflation.

It also complicates how they respond to the economic effects of the invasion and sanctions.
Russia’s role as the world’s third largest oil producer,the significance of the combination of Ukraine and Russia to grain markets – nearly 30 per cent of all wheat exports,75 per cent of global sunflower oil exports and key exporters of corn – and Russia’s importance in markets for metals like aluminium,nickel,palladium and titanium is causing sharp rises in the prices of all those commodities.

The invasion will cause the central banks to rethink the courses of their policies for the rest of this year.

Thus the flow-on effects from the invasion will add more inflationary pressures to already-unsustainable inflation rates.

Higher oil and other commodity prices - especially higher oil prices - are,however,growth suppressants. They will slow global economic growth.

The world’s central banks face the spectre of continuing high inflation rates and an abrupt slowing of economic growth. That was the combination that produced stagflation during the OPEC oil embargo in the 1970s.

Whether we get stagflation – high inflation and no economic growth – or just a slowing of growth while inflation rates remain high,the invasion will cause the central banks to rethink the courses of their policies for the rest of this year.

The threat of stagflation is unlikely to change the direction of monetary policies,given how elevated inflation rates were even before the invasion,but will probably change their pace. Fewer rate rises and a more cautious approach to quantitative tightening are probable.

Getting those settings right will be a difficult and delicate task,one made more complicated and even dangerous by the volatility and unpredictability of what might occur inside and outside Ukraine.

What’s obvious is that the assault on Ukraine is a tragedy for its people,faced with displacement and losses of lives,livelihoods and freedoms. It is also causing a financial and economic crisis for Russia,particularly its ordinary citizens,while threatening lost growth and living standards,at the very least,for the rest of the world.

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