The Fog of War: Ukraine, Unity & Risks of Stagflation

By Diane Swonk, chief economist, Grant Thornton

Russia’s invasion of Ukraine has done what the pandemic failed to do: It has unified much of the world against a common foe, Vladimir Putin. His unprovoked aggression toward Ukraine is acting as a cautionary tale against autocrats elsewhere, including China.

The sanctions on Russia are farther reaching and more punitive than in the past. The most dramatic move was the ban on transactions with Russia’s central bank. That stopped Russia from accessing billions in foreign exchange reserves that Putin had amassed to fund his war effort.

The ruble plummeted 30% in value the day sanctions were enacted. That forced Russia’s central bank to raise short-term interest rates to an unprecedented 20% to defend the exchange value of their currency and stem inflation. It will fail on both fronts, with Russia’s overly indebted households paying the price of Putin’s invasion.

Multinational companies are pulling back, cutting ties with state-owned companies and abandoning business in Russia. This is further isolating Russia while hitting its already fragile economy.

Western sanctions on Russian energy exports are being discussed. The goal is to deplete Putin’s financial reserves. That is remarkable, given the reliance the European Union (EU) has on Russia for its energy needs; Russia supplies roughly 27% of the EU’s crude oil and 38% of its natural gas.

Growth Slows

 Real GDP is forecast to slow to a 1.4% pace in the first quarter, after surging 7% in the fourth quarter of 2021. Spending weakened after catching up in the wake of the Delta wave last summer, while home buying and building remained elevated. Business investment picked up but inventories were drained. Government spending rebounded but not as much as we had expected; schools were forced back online and delayed reopening during the Omicron wave. The trade deficit hit a new record, as backlogs at our docks started to be cleared and exports slowed with lockdowns abroad.

Real GDP is expected to rebound at a 2.5% pace in the second quarter. Spending is expected to pivot from goods to services as consumers scramble to travel. Home buying and building is expected to soften in response to higher mortgage rates. Business investment is expected to slow with the exception of the shale industry. Inventories are expected to be rebuilt. Government spending is expected to remain relatively weak, unless a large fiscal 2022 budget can be enacted. The trade deficit is expected to narrow slightly.

Fed Hits the Brakes. The Federal Reserve is expected raise rates seven times and reduce their balance sheet in 2022. What would stop the Fed from acting? A seizure in credit markets, which would precipitate a harder landing than a Fed-induced slowdown.

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