Russian President Vladimir Putin’s decision to invade Ukraine will have many far-reaching economic implications. The first and arguably most important will be a sharp inflationary surge that could be temporary or permanent, depending on how long the conflict persists and how severe it becomes.
Energy markets are the barometer signaling the severity of Putin’s inflationary putsch. Oil prices rose about $6 per barrel as Russian forces mounted a broad assault, with the apparent goal of ousting Ukraine’s democratically elected government and installing a Putin puppet. That's on top of a "risk premium" of $5 or so markets applied in the weeks prior to the invasion. There are no disruptions yet in actual oil supplies, but the price spike indicates the obvious concern that there could be.
Russia is the world’s third-largest oil producer, responsible for about 11% of world supply. It’s the second largest natural-gas producer, with about 17% of world supply. The United States doesn’t consume much of Russia’s energy, because of strong domestic production. But Europe does, and oil and gas are global markets highly sensitive to supply and demand. In general, supply shocks in one part of the world push prices up everywhere, at least until new sources of supply make it to market.
So far, Russian energy continues to flow, and sanctions imposed on Russia by Europe and the United States, so far, exempt energy. But a number of risks are now greater than before Russia’s attack on Ukraine. Some Russian oil flows through Ukraine, and military activity could damage or wreck facilities crucial to moving it. The conflict could also escalate to the point where Europe decides to boycott Russian energy, or Putin decides to retaliate against Western sanctions by slowing or halting energy sales. This would be a draconian move either way, since Europe needs the energy and Russia needs the money. By invading, however, Putin has indicated he’s not really worried about economic damage he may cause, or be forced to bear.
Capital Economics predicts oil prices could rise another 30%, especially if there’s any sign of an actual supply problem. In the United States, that could easily push gas prices, now averaging $3.60 per gallon, well above $4. Rising energy prices would also raise costs for sectors that require a lot of energy, such as manufacturing and transportation, leading to higher producer and consumer prices in those parts of the economy.
Other supply disruptions
The Russia-Ukraine war could affect two other sectors: grains and metals. Ukraine and Russia are both major grain producers, and Russia is an important global supplier of aluminum, nickel, palladium and other metals. Again, supply disruptions could raise prices everywhere, even in countries that don’t get these types of goods directly from Russia.
Russian President Vladimir Putin looks on during a meeting with athletes, participants of the 2020 Tokyo Olympic Games, in Moscow, Russia September 11, 2021. Sputnik/Evgeny Biyatov/Kremlin via REUTERS ATTENTION EDITORS - THIS IMAGE WAS PROVIDED BY A THIRD PARTY. ·Sputnik Photo Agency / reuters
These factors could push inflation in developed economies higher by as much as 2 percentage points, Capital Economics economists said in a Feb. 24 briefing. In the United States, inflation is already running at a very uncomfortable 7.5%, so it’s possible inflation could approach 10% in coming months.
Putin certainly doesn’t care. In fact, he may relish any damage he’s able to cause the U.S. and European economies. “Surging energy prices could threaten a western recession, still another Putin goal,” Greg Valliere, chief strategist at AGF Investments, wrote in his Feb. 24 newsletter.
Few economists think Putin will get that wish. The U.S. economy in particular has many strengths and won't fall to Putin. Eurasia Group predicts that the Ukraine war will put more stress on supply chains already kinked by the COVID pandemic, with the net effect of about a 1 percentage point reduction in output. U.S. GDP growth in 2021 was strong, at 5.7%, adjusted for inflation. That leaves some headroom for geopolitical fissures.
Markets will repair some of the damage. The old saw about oil is that “the best cure for rising prices is rising prices.” That’s because higher prices make it more profitable for producers to bring oil to market, giving them incentive to restart idle rigs and even drill new wells. That’s already happening in the United States, with the number of active rigs up 62% during the last 12 months, according to Baker Hughes. President Biden has also hinted that a deal may be in the works to boost oil supply from producers that can quickly churn out more, such as Saudi Arabia and the United Arab Emirates.
The economic toll of Putin’s militarism also depends on how far he decides to go. If he succeeds in taking over Ukraine, it’s possible he could go further by menacing or attacking Ukraine’s southwestern neighbor, Moldova. A true nightmare scenario would be a Russian incursion into Romania, Lithuania, Latvia or Estonia, which used to be in the old Soviet orbit Putin pines for, but now belong to the NATO military alliance. An attack on any NATO country supposedly triggers a collective response by all the member countries, which could put the United States and most European nations directly at war with Russia.
It's also possible Putin has badly overstepped and will end up battling a draining guerilla war in Ukraine, much as the Soviet Union did in Afghanistan in the 1980s. Putin has prepared his country for sanctions, but they could end up more damaging than he realizes and weaken his hold on the country. These developments could check Putin’s ambitions and leave Ukraine as the final frontier of his territorial aggression.
Still, Putin seems to be resetting the European map in a way the West cannot easily undo. Western markets thrived during most of the Cold War, and they’ve shaken off geopolitical crises dozens of times. The risks are changing, however, and a period of adjustment is likely to be uncomfortable, at the least.
