Blame Ukraine conflict, not central banks

The origins of the inflation shock the world is experiencing are primarily political, not economic or monetary

The global economy faces a combination of slowing growth and rising inflation in 2022. Many commentators ascribe it to the excesses, fiscal and monetary, of the past several years. They are wrong. The deceleration in growth and inflation of the magnitude we are seeing now are more on account of the conflict in Ukraine.

To grasp this, you only need to look at forecasts before and after the Ukraine conflict that commenced in February 2022.

Let us take the growth forecasts first. The year 2022 was to have been the year of recovery for the world economy from the ravages of the second wave of Covid in 2021. In October 2021, the International Monetary Fund’s World Economic Outlook (WEO) saw the world economy growing at 4.9 per cent. In its April 2022 issue of WEO, the IMF projects world economic growth at 3.6 per cent in

2022 or 1.3 percentage points below the October 2021 forecast. Note that the April forecast is 0.8 percentage points below the forecast of January 2022, a month before the Ukraine conflict erupted.

So, yes, the world economy was slowing even before the conflict in Ukraine. Prices of commodities had started rising due to the recovery in the world economy. Central banks had started responding with an increase in interest rates and this was impacting private consumption and investment.

But Ukraine has greatly amplified the deceleration in growth. The sanctions against Russia have no precedent and have disrupted long-standing supply chains and trade linkages. Inflation, as we shall see, has received an enormous boost. Capital flight from emerging economies is putting pressure on exchange rates, giving central banks another reason to raise interest rates.

Increases in interest rates threaten to undermine government finances across economies. Western banks are poised to take a hit of around $10 billion on their exposures to Russia. Western corporates retreating from Russia face huge write-offs. There is, above all, uncertainty about the course of the war and the possibility of secondary sanctions against nations found to be violating sanctions imposed on Russia. All this will tell on growth. One cannot compare the slowdown projected prior to February 2022 with what faces us post-ukraine.

The comparison of trends in inflation pre- and post-ukraine is even more compelling.

The World Bank’s Commodity Markets Outlook (April 2022) shows that between January 2020 and December 2021, that is, over 24 months, energy prices rose at a compounded annual rate of 22.4 per cent. In 2022, in just three months from January to March, energy prices rose by an additional 34 per cent! Nonenergy commodity prices rose by an annual rate of 18 per cent over the previous two years. In the first three months of 2022, these rose by an additional 13 per cent.

As a result, the World Bank’s forecast for energy prices in April 2022 is 92 per cent higher than in October 2021. For non-energy commodities, the forecast is 49 per cent higher. The forecast for food prices is a good 57 per cent higher. The Ukraine conflict has caused prices to soar in a way that central banks could not have anticipated earlier.

It makes no sense to criticise governments for having boosted spending, first after the global financial crisis (GFC) of 2007, and then after the Covid crisis. Nor can central banks be faulted for policies aimed at supporting growth. These policies saved the global economy from collapse after the GFC. They were also successful in containing the damage from the Covid crisis, in particular, to vulnerable groups, such as the poor and small enterprises.

Proponents of Modern Monetary Theory (MMT) contend that the only limit to government spending

It makes no sense to criticise governments for having boosted spending, first after the global financial crisis of 2007, and then after the Covid crisis. Nor can central banks be faulted for policies aimed at supporting growth

is inflation, not the government’s capacity to repay borrowings through future taxes. Critics of MMT say that its advocates have seriously underestimated the inflation risk to government spending. This is by no means obvious. It is more plausible that the fault lies, not in the economic policies of well over a decade, but in the stars of NATO. The inflation shock we are seeing is political in origin. It is primarily on account of NATO’S opting for a head-on confrontation with Russia over the eastward expansion of NATO.

Commentators say central banks have been late in reacting to inflation. This is strictly hindsight. Our analysis above suggests that prior to Ukraine, the US Federal Reserve was justified in waiting to see if the supply disruptions caused by Covid had played out. It had grounds to believe that a series of 25 basis points increases in the policy rate would suffice to head off inflation. No central bank can anticipate the sort of supply shock that has emanated from Ukraine.

Similarly, the Reserve Bank of India (RBI) may not have erred in forecasting an inflation rate of 4.5 per cent for India in 2022-23 last February. The revision in the inflation forecast to 5.7 per cent that happened in April is strictly a post-ukraine event.

At a forecast inflation rate of 4.5 per cent, the RBI had grounds for prioritising growth over inflation. As long as inflation is within the band of 6 per cent, it is appropriate to prioritise growth especially at a time when the growth rate has been below the trend rate. When the inflation forecast moves closer to 6 per cent, it is appropriate to prioritise inflation. Those who say that the RBI should be fixated at all time on an inflation rate of 4 per cent forget that there was a question mark over the continuance of the present band mandated for the Monetary Policy Committee. The argument was made that, in the interest of facilitating a higher growth rate, the target rate for inflation could be raised to 5 per cent plus or minus 2 per cent.

The government decided to stay with the present mandate, perhaps, because it thought that relaxing the monetary policy target at the same time as the fiscal deficit target was being continuously deferred would unsettle foreign investors. Against this background, the RBI cannot be faulted for its interpretation of the inflation mandate.

The outlook for both growth and inflation has changed dramatically as a result of a force majeure event, Ukraine. It makes little sense to fault demand management for the effects of an unprecedented supply shock.