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Geopolitical developments complicate central bank decision making

Khatija Haque - Head of Research & Chief Economist
Published Date: 07 March 2022


The developments in Ukraine over the last week, and the sanctions imposed on Russia as a result, have had a significant impact on financial markets and increased the risks and uncertainties facing the global economy.  Policy making has become even more challenging in a fluid environment as some of the consequences of the economic sanctions imposed on Russia are still unclear.

In the near term, inflation risks have increased significantly.  Russia and Ukraine are major exporters of food and industrial commodities, exports of which have been disrupted by the war and the sanctions on Russia. Russia also accounts for around 12% of the world’s oil exports and around 25% of natural gas exports. While energy is excluded from the sanctions for the time being, demand for Russian oil exports has declined as buyers and financial institutions are wary about transacting with the country. Consequently, oil prices have surged more than 65% since the start of this year, to over USD 130/b at the time of writing, while wheat prices have jumped more than 70% since mid-February.

Conventionally, central banks would look through one-off spikes in food and energy prices and focus instead on core inflation.  However, with inflation in the US and Europe already at multi-decade highs, and core inflation also running above the 2% targets, the surge in commodity prices has increased pressure on central banks to tighten monetary policy even more aggressively.

Despite this pressure, markets are pricing a slower pace of rate hikes from the US Federal Reserve and the ECB this year than they were before Russia’s invasion of Ukraine, and officials from both the Fed and the ECB have signalled caution.  In his semi-annual testimony before congress last week, Fed Chair Jerome Powell acknowledged both the increased inflation risk and the strength of the US economy, but said he would propose and support a 25bp rate hike in March rather than the 50bp increase that some of this colleagues in the FOMC have recently called for. He was perhaps more specific in his comments than he had been previously as he sought to “avoid adding uncertainty to what is already an extraordinarily challenging and uncertain moment”.  However, he did leave the door open to more aggressive tightening if inflation comes in higher or remains higher for longer than the Fed currently expects. 

One of the uncertainties facing the Fed is that high oil prices usually weaken consumer demand and lead to slower economic growth. As consumers have to spend more money on fuel, there is less to spend on other goods and services.  To the extent that oil prices remain high for an extended period, it could mean the Fed wouldn’t need to tighten monetary policy as much to dampen demand.  At this stage however, Emirates NBD expects the Fed to raise rates both in March and May as it prioritises its price stability mandate in the face of surging food and energy prices, and strong wage growth. 

Europe is likely to see a bigger impact from the disruptions to trade and the impact of sanctions on Russia on its own economy. When the ECB meets this week, it is likely to revise its growth forecasts lower and inflation forecasts substantially higher.  However, policy makers have emphasised caution given the heightened uncertainty and low visibility in terms of economic outcomes. Moreover, the Eurozone countries have committed to increasing defence spending and will need to provide additional support for refugees as well, which would likely mean increased debt issuance. This may require further support from the ECB in the form of asset purchases this year even as it seeks to normalize monetary policy to tackle inflation.  

Click here to read this column in The National