The global economy’s growing risks: stagflation, refugees and lockdowns

This was supposed to be the year the world economy recovered from the shock of Covid-19. By the end of 2022, official forecasters expected the US, European and Chinese economies almost to have returned to the paths they were cruising along before the pandemic. Other emerging economies were lagging behind, but they also expected to be growing at rapid rates and slowly getting back to normal.

Inflation was a problem, for sure, the IMF said in its October assessment, but it said that rapid price growth “should gradually decrease as supply-demand imbalances wane in 2022 and monetary policy in major economies respond”.

The fund was not naive. It noted geopolitical and pandemic risks in its assessment, but hoped they would be dodged. Three months into 2022, those warnings have become reality and the global economy is now facing the risk of a sharp deterioration.

Russia’s invasion of Ukraine is imposing a severe stagflationary shock, raising prices as energy supply is threatened and squeezing household and corporate incomes as essential commodities become more expensive.

With the largest war on European soil for almost 80 years, the threat of escalation undermines confidence to spend and Europe must deal with an even larger influx of refugees than in 2015. The return of coronavirus to China once again threatens global supply chains, amplifying upward pressures on prices and downward pressure on output.

These developments all undermine global economic prospects. But they are also shrouded in so much uncertainty that Mathias Cormann, head of the OECD, said this week that the organisation was “not in a position to present” its usual global economic outlook.

Nathan Sheets, global chief economist at Citi and a former US Treasury official, has been more willing to put a very rough estimate on the potential harm. Before the war, global growth was expected to be in the region of 5 per cent in 2022, but Sheets reckons “if the [Ukrainian] tensions are prolonged or escalate further, the markdowns to this year’s growth outlook may need to be denominated in percentage points”.

Across the world, policymakers have been taking action and pivoting towards a more gloomy outlook. A little over a month ago, Christine Lagarde, president of the European Central Bank, presented an upbeat view of the eurozone outlook, predicting “growth should rebound strongly”, but this week she changed her tune, saying recent events “posed significant risks to growth”.

Worrying about the surge in US inflation, Federal Reserve chair Jay Powell initiated a series of interest rate increases, saying he was “acutely aware of the need to return the economy to price stability and determined to use our tools to do exactly that”. China’s top economic official, Liu He, was sufficiently worried about the situation to make a rare intervention on Wednesday, promising the government would “boost the economy in the first quarter”, as well as introduce “policies that are favourable to the market”.

Being closest both geographically and economically to Ukraine, Europe’s economy is most vulnerable. While the OECD did not produce forecasts, it published a simulation of the likely effects of the war and commodity price changes lasting all year. This showed drops in growth almost twice as large in the eurozone as in the US. “There is a real difference between US and Russian gas prices and the shock is larger [in Europe] because it has much more dependence on Russian gas,” says Laurence Boone, chief economist of the OECD.

The organisation simulated a 1.4 percentage point hit to Europe’s economy in 2022, based on the effects so far, but officials are worried this underestimates the true economic impact. Although oil prices have fallen this week, partly as a result of a worse global economic outlook, officials are not taking much comfort from these developments.

Speaking privately to the Financial Times, one senior European economic official was worried about “a really big confidence effect” on households and companies once the true consequences of Russia’s actions and disruptions to European supply chains were felt.

The official added that the conflict would also require huge pan-European solidarity with Poland and other eastern European countries facing the largest burden of finding accommodation and support for the 3mn refugees that have already crossed the Ukrainian border, with many more millions expected.

Already, governments in Europe are cranking up their policy levers in a bid to protect households from some of the worst effects of higher commodity prices on their living standards. The French and Irish governments have agreed to subsidise higher fuel costs, with Germany signalling it would soon follow suit.

But these actions are not preventing economic effects of the invasion becoming all too visible to consumers and companies. German carmakers have idled factories due to shortages of parts made in Ukraine, and some Italian supermarkets are even running short of pasta. Spanish truck drivers went on strike this week in protest at high fuel costs, creating empty shelves in supermarkets.

Herbert Diess, the chief executive of Volkswagen, told the FT this week that a prolonged war in Ukraine risked being “very much worse” for the European economy than the coronavirus pandemic, due to supply chain disruption, energy scarcity and inflation.

Global supply chains have already been heavily disrupted by the pandemic and bottlenecks, but the war in Ukraine presents a fresh risk to the supply of key materials. For instance, Ukraine supplies 70 per cent of neon gas, which is needed for the laser lithography process used to make semiconductors, while Russia is the leading exporter of palladium, which is needed to make catalytic converters.

The worst-case scenario modelled by economists and central banks is if Russian energy supplies to Europe are cut off. Jan Hatzius, chief economist of Goldman Sachs, estimates an EU ban on Russian energy imports would cause a 2.2 per cent hit to production and trigger a eurozone recession, defined as two consecutive quarters of economic contraction.

Rishi Sunak, UK chancellor, has been telling colleagues the hit would be larger and would quickly cause a downturn worth £70bn, or 3 per cent, of gross domestic product in the UK, given its still-close ties to the continental European economy.

While there were hopes that Europe’s economy might grow faster than the US in 2022, few now think that likely. Vitor Constâncio, the former vice-president of the ECB, warns a recession is possible, regardless of what happens in the war, if confidence is lost. “With quantitative shortages growth could go down even more and perhaps even turn negative this year, because we would have panic and animal spirits would be very low, while savings would increase.”

Few policymakers are yet in panic mode, but, far removed from eastern Europe, they are all now seeking to maintain confidence to prevent much worse economic outcomes in 2022. Actions differ because the problems are not uniform in the major economies.

In contrast to Europe, the US economy is running too hot, with unemployment at 3.8 per cent in February almost back to the pre-pandemic rate of 3.5 per cent, and inflation at a multi-decade high last month, with consumer prices 7.9 per cent higher than a year earlier.

After imposing the first interest rate rise since the pandemic, the Fed signalled this week it intended to repeat the process of quarter-point rises six more times this year and three more in 2023. The objective, in the Fed’s eyes, is to make monetary policy restrictive for the first time since the global financial crisis, with interest rates of almost 3 per cent.

The enormity of this shift towards seeking to slow the US economy can be shown by how much the Fed’s messaging has changed. A year ago it was guiding that interest rates would be barely 0.5 per cent by the end of next year.

Although in the US monetary policy is taking a lot of the strain in seeking to guide the economy through a difficult time, around the world there is an increasing recognition that fiscal policy is likely to be better suited to restoring confidence in economic structures.

The US cannot easily offer further stimulus for its overheating economy, but that option should be used in Europe, according to Reza Moghadam, chief economic adviser at Morgan Stanley. “The policy tool really has to be fiscal this time,” he says, adding there is only so much even this can achieve. “Governments can offset some of the costs to consumers and businesses but it is difficult to offset the impact on trade or the hit to confidence from higher energy costs.”

The OECD estimated that fiscal firepower — stimulus in Europe and China while delaying consolidation in the US — would be sufficient to halve the direct hits to economic output from the war in Ukraine and this would not be inflationary if it were targeted to poorer households, who are much harder hit by higher food, heating and electricity costs.

China’s signal that it would bring forward a package of support as the Omicron wave threatens to extend lockdowns across large areas of the country came as the government also paused plans to expand trials of a new property tax. Liu’s pledges to support the economy were unspecific but halted a rout in Chinese equities — even if analysts were unconvinced the government was ending its punishing regulatory overhaul of business.

In the US, the administration is leaning more on browbeating industry. President Joe Biden took to Twitter this week to lambast US oil companies for not lowering fuel prices quickly for drivers at the pumps as global oil prices fell back. “Oil and gas companies shouldn’t pad their profits at the expense of hard-working Americans,” he said.

No one is confident they know how these policy responses, drawn up in haste to the fast-changing economic reality, will work. All most economists are willing to say is that the global outlook in 2022 will be worse than they previously expected and how bad depends on the war.

As Joseph Capurso, head of international economics at the Commonwealth Bank of Australia, wrote this week: “War, above all else, is the ultimate expression of politics. Politicians, rather than business people or bureaucrats, have made decisions that if not reversed, could have profound implications for the world economy in the short and long term.”