Has the Ukraine war caught central banks asleep at the wheel?

Volatile geopolitics has left policymakers with no easy choices

May 06, 2022
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The US Federal Reserve is facing particular scrutiny. Photo: Martin Shields / Alamy Stock Photo

Now the US and the UK have seemingly embarked on a determined attempt to bring inflation down, the question is: have they left it too late? 

When Russia announced on 27th April that it would cut gas supplies to Poland and Bulgaria for refusing to pay in roubles there was an instant 20 per cent increase in European gas prices. Things could get worse if the same policy is extended across the EU, given that the bloc relies on Russia for 40 per cent of its gas imports and other energy sources will be difficult to obtain in time. In that environment, spot prices (the current price at which an asset can be immediately bought or sold) could rise further, affecting wholesale prices and then inevitably the consumer. The cost of living will be hit further by rising food prices as supplies from Russia and Ukraine, on which much of Europe depends, remain restricted.

One wonders what monetary policy could do—and could have done—better. A number of central banks are now raising interest rates and stopping, slowing down or even reversing the regular injection of liquidity, known as Quantitative Easing (QE)—buying government bonds in the secondary market—which was ramped up at the beginning of the pandemic. Among them, the European Central Bank is the most hesitant to raise rates. One presumes it is fearful of repeating the mistakes of its former president Jean-Claude Trichet, who hiked them twice in 2011, just as the eurozone was falling back into recession and a period of deflation.  

But given the sharp rise in inflation, central banks around the world are coming under increasing criticism for not tightening earlier and faster this time round. Record low interest rates have distorted markets, inflating the value of assets and leading to one of the sharpest-ever increases in private debt. And, the argument goes, this loose policy carried on for too long after we had started to recover from the Covid recession. The Federal Reserve in the US, where the drop in GDP in 2020 was relatively small and the effect of the pandemic on activity relatively short-lived, is under particular scrutiny.  

Yet the lesson from the financial crisis is that QE, in helping to finance the necessary fiscal stimulus while lowering interest rates, played a significant part in the recovery. And a 2016 Bank of England analysis that looked at US QE operations after the financial crisis suggested  that the expansion of one central bank’s balance sheet as it conducts monetary easing can have significant spill-over effects—and a positive impact on cross-border economic activity too.  

It was not clear this was the best moment for a hawkish turn. Yes, energy, commodity and transport costs were beginning to rise faster than anticipated, even before the Russian invasion. But much of that was arguably a global phenomenon that could not be reversed by a single country’s tightening of monetary policy. And with fiscal support being gradually withdrawn by most governments and geopolitical uncertainties rising, the path of post-pandemic recovery has been volatile, justifying a more cautious approach by central bankers. They also had to consider thatjust before the invasion, supply chain constraints seemed to be easing, with freight costs also down and some signs of a return to normality on the horizon. In late 2021, the consensus seemed to be that commodity and energy prices would more or less stabilise in the following year, albeit at high levels. And the world economy was slowing anyway, which in itself would moderate demand and therefore the pace of price increases.  

Russia’s invasion has meant a real change in perceptions. Food and energy prices have faced dramatic upward pressure. A quick end to hostilities failed to materialise. The IMF has a downside scenario which makes for grim reading. How seriously can one therefore take its baseline case, which has oil prices falling by some 13 per cent for 2023 as a whole after a 54.7 per cent rise this year, and other commodity prices declining by 2.5 per cent after a 11.4 per cent hike in 2022. And while consumer inflation in advanced economies rises to a higher 5.7 per cent in 2022, it drops down to just 2.5 per cent in 2023.

So should we relax? Or are we in for more upsets? It is worth remembering, in semi-defence of central bankers, that within just six months the IMF has revised its own inflation prediction for 2022 upwards by 3.4 per cent. So in effect, everyone more or less has been getting it wrong as we have been moving in uncharted waters.  

And even now, with the war still raging, the baseline forecasts assume a return to inflation being pretty close to target, though a year later than originally thought. Some inevitable monetary and fiscal tightening is assumed in the forecasts. But the important issue for policymakers is how to read the tea leaves correctly to get to that happier place on inflation, while avoiding plunging their economies back into recession, as happened in the eurozone a decade ago. And everyone will look nervously at the small drop in US GDP in Q1 2022, the first quarterly decline since early 2020, and wonder whether the tightening we are beginning to see in fact makes any sense at all.