For a better browsing experience and to benefit from all the features of, we advise you to use the Edge browser.
  • Text Size
  • Contrast
The war in Ukraine has upended economic forecasts. Its effects have been immediate and hugely disruptive, through three main channels. First on confidence, by injecting uncertainty; next on supply, by triggering actual or expected shortages; and third on demand by stoking inflation.

While countries are set to experience very different spillovers from this latest shock, based on how detached they are from the conflict, how dependent they are on the countries involved and how strong their post-pandemic economies are, none is immune to accelerating inflation, which is already dangerously high. As such, although the Federal Reserve is concerned by domestic inflation, it is unlikely to be very moved by the conflict’s threats to growth, which are primarily in other countries.

The war in Ukraine has plunged us in disbelief into an environment that is dramatic and more uncertain than ever. However, outlining economic scenarios requires forward-looking assumptions. And, in concrete terms, with military and diplomatic outcomes looking equally likely, we have to adopt some semblance of a scenario, not a core scenario that is highly likely to occur, but a median one. Median in the sense that it is between the two extremes of increased escalation and a rapid return to peace.

The war in Ukraine has upended economic forecasts. Its effects have been immediate and hugely disruptive through three main channels. First on confidence, by injecting uncertainty; next on supply, by triggering actual or expected shortages; and third on demand by stoking inflation.

While countries are set to experience very different spillovers from this latest shock, none is immune to inflation. Inflation is already dangerously high in the wake of the pandemic and is accelerating further on the back of sharp rises in commodity prices (energy, but also industrial commodities and food), further supply chain disruptions and risks of shortages. Our scenario is now pricing in average inflation of 6.8% in the Eurozone and 7.6% in the United States. 

Just like when the Covid pandemic broke out, a ‘hierarchy’ of vulnerability will be established based on several criteria : (1) how far the countries are from the war zone; (2) how much do they trade with Ukraine and Russia (including how dependent they are on grain, natural gas and oil imports, and their energy mix); (3) how sensitive they are to industrial inputs that are likely to be rationed; (4) how strong their post-pandemic economies are; and (5) how easily they can mitigate price increases (particularly through government subsidies) and terms of trade, which are particularly sensitive for emerging countries.

The US economy is far away from the epicentre of the conflict; it is largely insulated and still driven by a post-Covid recovery bolstered by overstimulated consumption; it is expected to hold up well in 2022. Thanks to financially-sound households that have accumulated high levels of savings (mainly among high earners) and a tight labour market that has seen wages rise sharply (mainly benefiting low-income households), US growth (projected at 3.3% in 2022) could absorb the soaring inflation and the Fed’s more severe monetary policy tightening and come out above potential.

The Eurozone has its own shock absorbers, including the excess savings accumulated by households and the support for investment from the European NGEU funds combined with national resilience and recovery plans. However, despite the additional fiscal support to mitigate the impact of inflation on household income (but also on corporate profitability), the foreseeable decline in their purchasing power coupled with a likely dislocation of supply suggests that growth forecasts will be revised sharply down. Based on inflation revised up from 2.9% to 6.5%, 2022 growth would drop from 4.4% to 2.9% under a ‘median’ scenario that entails increasing extreme risks (including a reduction or stoppage of Russian energy supply) and brings a form of fragmentation just like the pandemic.

Finally, in the emerging world, new fissures are forming. The most impacted and/or vulnerable countries include Central Europe, which is close to the eye of the storm, and low-income countries, especially net importers of food and energy that are suffering from a lack of flexibility when it comes to their budgets and their imports. Oil producers in general (Gulf nations in particular) and South America are in the best positions (at least temporarily) and are benefiting from a potential increase in their net commodity exports, but also (and more importantly) improved trading terms. Generally speaking, Asia is somewhere in the middle. Meanwhile, China is simultaneously dealing with the biggest Covid wave since March 2020, the continued contraction of the real estate sector and external demand that is likely to be eroded by the war. Provided that support measures are implemented (and effective), growth is expected to come out at just under 5%. Two factors that provide some hope that the authorities will react are the absence of inflation and the 20th Party Congress at the end of 2022.

On the financial markets, monetary policy tightening was already on the cards, modulated according to the intensity of what has become a global concern – accelerating inflation. And now tightening measures must be bold enough to tackle the potential adverse shocks of the Russia-Ukraine conflict. The Federal Reserve’s determination will continue to contrast with the constrained normalisation policies of the ECB and the Bank of England.

In the US, the FOMC’s sharp hawkish shift in late 2021 has only been extended over the first three months of 2022. Rhetoric suggests that the Fed will do whatever is needed to control inflation. Our 2022 scenario is less aggressive than the market and forecasts a two-stage tightening – aggressive in H1 (100bp) and measured H2 (50bp), bringing the Fed funds target range to 1.50 1.75% at end-2022.

In the Eurozone, inflation is accelerating, but the economic outlook is deteriorating. Although it is generally favourable, there is a risk that it will reveal dangerous divergences between countries. The ECB will have a delicate balancing act. The central bank would be ‘happy’ if its vigilance in the face of inflation is not synonymous with an overreaction. Purchasing programmes are coming to an end. The exceptional Pandemic Emergency Purchase Programme (PEPP) was halted at the end of March and the classic Asset Purchase Programme (APP) will come to an end in Q3. The end of quantitative easing will not automatically be followed by a rise in interest rates. The pace of tightening remains to be seen. It will depend on the economic data and is expected to initially take the form of a hike in the deposit facility rate late this year. Moreover, in addition to securities purchases and interest rates, starting in the summer, TLTRO III will help to tighten liquidity conditions. 

Aggressive or measured, monetary policy tightening is pushing up short-term rates. Structural factors, as well as questions around whether inflation is here to stay and whether the recovery will last, will tend to slow the pace of increases in long-term rates. Our scenario is forecasting US and German 10-year sovereign rates at close to 2.00% and 0.90%, respectively, at the end of 2022. As quantitative tightening, which has been a powerful anchor, starts, non-super core Eurozone sovereign spreads are expected to widen.

Click here to consult the ECO publication.