Will there be a growth and inflation trade-off?

The Russia-Ukraine conflict is another global supply shock with the same consequences of weaker growth and higher inflation.

COVID-19 was an adverse global supply shock that cut growth and raised inflation, albeit not at the same time. Central banks responded by easing monetary policy substantially and only later started to hike. Fast-forward to now, and the Russia-Ukraine conflict is another global supply shock with the same consequences of weaker growth and higher inflation. But this time, central banks are more likely to tighten policy than ease it.

Supply shocks are rare. Fortunately, because they are much more difficult for policymakers to deal with than demand shocks (which send growth and inflation in the same direction).In the COVID shock, the central banks responded to the slump in growth at first because (a) it came far sooner than expected (and inflation initially fell) and (b) they underestimated the inflation shock. Of course, they are scrambling to catch up with the surge in inflation. This next supply shock stemming from the Russia/Ukraine conflict will impact growth and inflation far more simultaneously. Prices will rise straight away due to higher food and energy prices, and growth will be hit by a collapse in confidence. The lack of sequencing denies central banks the space to ease and then tighten the liquidity that they had through the pandemic. So, what should they do? Keep tightening, or even step this up given the impending rise in inflation, or stall and, possibly even ease policy to counter the hit to growth?

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, thinks that there are two factors that should determine the response. The first is to consider where economies stand as this crisis hits. And the second is to try to gauge the longevity of the inflation and growth risks. On the first of these, economies have come into this crisis in a strong position thanks to the very aggressive easing of policy in 2020 on the fiscal and monetary fronts, neither of which has been reversed. The quick retreat of the Omicron variant of the coronavirus also means that there has been a spring in the step of the global economy as sectors of the economy reopen. And, of course, inflation has not just been on the rise but is insidiously threatening to morph into a massive longer-term problem rather than the short-term annoyance that policymakers thought at first.

In Mr. Steve Barrow’s view, these things present a powerful case for tightening monetary policy. The question now is whether the Russia/Ukraine conflict undermines these arguments. For, unlike in the past, when central bankers attempted to "look through" food and energy inflation by using "core" price measures that excluded the pair, this time it appears to be more permanent."We are not talking about a temporary refusal to supply sufficient energy (as we have seen with OPEC in the past), or a temporary hit to growth that reduces oil demand (like the pandemic). Here we could be looking at the ostracizing of the world’s third largest oil supplier and second largest gas supplier", Mr. Steve Barrow said.

In the most optimistic (but perhaps unlikely) scenario, Russia pulls back from Ukraine, just holding onto the disputed regions of Donetsk and Luhansk. It will still take a long time to mend relations with the West, and ease sanctions. A more likely occupation of Ukraine by a Kremlin-installed puppet government, or worse still, an attack against another country, would surely freeze Russia out of global energy supply as quickly as importers could find alternatives.

In other words, it seems hard for the West – particularly Europe – to see this as a temporary energy shock, and it should adjust policy accordingly. The adverse growth shock may seem sharp at first, but Mr. Steve Barrow suspects that it won’t be as long-lived as it was before. All told, policymakers need to adjust policies in the same way as they did following the averse oil supply shocks of the 1970s, which was to lift rates. This is what they will do, even if some, notably the ECB, drag their feet at first.