25 February 2022: Bailey warns of real risk of inflation

25 February 2022: Bailey warns of real risk of inflation

Bailey warns of real risk of inflation

25th February: Highlights

  • Johnson plans to hobble Russian economy
  • Ukraine casts doubt over U.S. recovery
  • EU heavily dependent on Russian energy

But Ukraine may add to slowdown in global economy

The task facing the Bank of England and other Central Banks has been made much harder by Russia’s invasion of Ukraine.

If the conflict in Eastern Europe continues for a period of months, the effect on the global economy could be catastrophic. As Russian tanks crossed into Ukraine yesterday, the price of a barrel of oil rose above $100 for the first time in seven years and the wholesale price of gas, which has already quadrupled in little over a year, rose by 60%.

With inflation in the UK already at 5.4% and rising. Just as the country is emerging from the Coronavirus Pandemic, another major situation has now arisen.

A further significant rise in the cost of energy will no doubt push inflation even higher than had been predicted, while if the oil price remains above $100, it will hit global growth hard.

The World Bank had already predicted that global growth in 2022 would be 4.1%. This was down from its earlier prediction in October of last year of 5.5%. There is little doubt that it will be revised lower again when the data is updated at the end of next month.

The UK does not directly receive any oil or gas from Russia, so it will not be affected by supply difficulties in the short-term. but the rising price will add to inflation.

This, when added to a slowing global economy, will mean that the Bank of England will need to tread carefully when deciding monetary policy if it is to avoid sending the UK economy into recession.

Over the past week, a number of members of the MPC have spoken of their belief that interest rates will need to rise further in order to bring inflation under control. With a likely slowdown in the rate of growth, the economy could face stagflation where prices continue to rise while activity and output are falling.

Sterling continued to fall yesterday as risk appetite was severely curtailed by the conflict in Ukraine. It reached a low of 1.3275, but bounced back to close at 1.3390. overnight, it has recouped some more of its losses from yesterday, so far (at 0500), reaching 1.3430.

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Half point increase is becoming more likely

The Russian invasion of Ukraine has challenged the long-held view that the ability of superpowers to wipe each other out in any global conflict balances their ambition.

When the first wave of Russian forces crossed the Border into Ukraine yesterday, the Russian President made a speech that will resonate long and hard throughout the capitals of many countries.

Vladimir Putin spoke of what would happen should there be any action taken to try to halt Russian ambition, declaring that anyone who considers interfering from the outside would face consequences greater than any they have faced in their history.

President Biden made the expected noises about the invasion condemning Putin’s actions, and while the U.S. has deployed more troops in neighbouring NATO member countries, there is no chance of the U.S. becoming directly involved in the conflict.

It seems that, at a stroke, Putin has tried, and so far, succeeded, in changing the world order.

The sanctions that have been announced by the U.S., UK and EU will no doubt affect the Russian economy, but Putin was warned well in advance of what would happen and has taken the decision to invade anyway.

The Federal Reserve is still considering its next monetary policy action, while Jerome Powell is no doubt in discussion with his colleagues from the FOMC about next month’s tightening.

Yesterday, Powell spoke of his determination that the Fed’s independence would not allow it to be concerned about the midterm elections that will take place later this year.

It has already been well documented that there are concerns that if the Fed front loads interest rate increases by making two fifty-point hikes before the end of the half-year, that they could slow the economy to such an extent that it comes close to recession.

When the expected slowdown created by any prolonged conflict in Eastern Europe is factored in, the Fed’s task becomes significantly tougher.

The dynamics of the world’s largest economy are such that the rest of the developed world will be closely listening to comments from FOMC members to try to learn their intentions, as well as watching economic reports like next week’s employment data for February.

Yesterday, the dollar index rose to a high of 97.73 as risk appetite was decimated. It eventually closed at 97.09 but is likely to remain well-supported until events in Ukraine become clearer.

A 2022 recession now more likely

Just when the Eurozone had begun to emerge from the Coronavirus Pandemic, another major global event threatens to swamp it.

The Russian invasion of Ukraine has delivered a probable knockout punch to any chance of the EU seeing any growth in 2022.

There were already concerns being expressed that there would be a recession this year, and it was announced this week that the economy probably contracted in Q1. Now, with sanctions against Russia being applied and some retaliation likely from Moscow, the outlook looks bleak.

Brussels announced restrictive measures will be applied to all 351 members of the Russian Duma (Parliament) calling Russian actions illegal and unacceptable.

Ursula von der Leyen, the EU Commission President, called the Russian invasion barbaric and denounced the cynical arguments used to justify it.

The EU gets 40% of its gas from Russia and 30% of its oil. There is little doubt that not only will the price of those imports skyrocket, but they may also become unavailable, since Putin is sure to weaponize his country’s energy exports.

Three of the largest EU economies will be most badly hit by the conflict. Italy and France get far more of their energy from Russia than the EU average, while relations between Germany’s former Chancellor Angela Merkel and President Putin were such that there were several commercial links between the two countries.

Work on the second gas pipeline between Germany and Russia has already been suspended, and it is certain that Germany will receive a major blow to its economy when it begins to see the results of sanctions.

Pressure on the ECB to continue to support the economy will rise due to this new development. As growth falters, it will become more difficult for hawkish members of the Governing Council to continue to push for action to bring down inflation.

The euro suffered yesterday due to both global risk aversion and the region’s proximity to the conflict. It fell to a low of 1.1106 but recovered a little to close at 1.1199.

Have a great day!
About Alan Hill

Alan has been involved in the FX market for more than 25 years and brings a wealth of experience to his content. His knowledge has been gained while trading through some of the most volatile periods of recent history. His commentary relies on an understanding of past events and how they will affect future market performance.”