What’s common in the Northern Ireland protocol, the Russian sanctions and inflationary pressure? All of them are dealt with by trying to square the circle. The UK government has been emphasizing for six years now that Brexit means Brexit, but it appears to backtrack when leaving the EU comes with a border in the Irish Sea. The international community is attempting to starve Russia of its petrodollars but does everything to mitigate the price impact of its own action. The US has gone as far as exempting one autocrat (Venezuela) from oil sanctions to make up for the shortfall in supply from another. Central banks aim to tame rising inflation without hindering economic growth. By unilaterally re-writing parts of the Brexit agreement the UK is on the path to worsen its acrimonious relationship with its biggest trading partner at the expense of growth. Russia is now enjoying higher oil revenues than it did pre-invasion despite reduced production and exports. Vladimir Putin was probably correct when he asserted last week that the impact of the sanctions on his country has had a more severe effect on the western world than on Russia. The MSCI Global Equity index has lost 15% of its value since February 23 but the Russian stock market has recovered from the initial slump and is 13% higher than it was four months ago. The latest shock came last week when central banks kept throwing in the towel one after the other and warned that the collateral damage of fighting inflation will be sluggish economic growth. Clearly, the global economy is suffering from intense price pressure caused by an impressive rise in post-Covid aggregate demand and supply chain bottlenecks greatly exacerbated by the Ukrainian conflict. It is the persistent inflationary pressure that showed its true colour last week and forced the masters of monetary policy to admit that their optimistic view of transitionary inflation was misplaced, and interest rate hikes are a must.
Not that anyone could foresee Russia’s invasion of Ukraine in 2021. Investors deserted equities en masse last week after it became unequivocal that central banks will do “whatever it takes” to bring inflation under control. In the last six months nearly 50 countries hiked borrowing costs in the hope that inflation can be brought down without jeopardizing economic expansion. And then last week came the painful admission that the economic results of rate increases will be widespread and will, in fact, put a break on growth. The world’s biggest economies, the US, the EU and the UK have all upped benchmark rates. The goal of taming inflation to the generally acceptable 2% without hindering economic expansion has turned into wishful thinking and it is now expected that growth will be under strain in the foreseeable future with diverging consequences for different parts of the world.
In the US the job market could come under pressure. Last week’s 0.75% rate increase, the biggest since 1994 could be followed by a similar hike in July. The official projection is now a rate rise to 3.8% by 2023, with the biggest jump pencilled in for this year. Cooling inflation from last month’s 8.6%, the fastest increase in more than 40 years, is the new priority and it means that the job market could inevitably suffer. The recent gains in the domestic economy, and the historically low 3.6% unemployment rate will be in jeopardy as the Federal Reserve admits that achieving “soft landing” in the fight against inflation will be a tall order. Rising borrowing costs will adversely affect demand, will make companies to cut back on investment plans, which should lead to a spike in unemployment and a drop in growth rates.
The battle the EU faces is a different type of challenge. Firstly, because of its geographical proximity to Russia it is more gravely impacted by the Ukrainian crisis than the US. Secondly, although the eurozone shares a common currency, it has 19 different bond markets and therefore 19 different borrowing costs. The ECB announced its plan to raise rates and to halt its bond-buying programmes after inflation rose to 8.1% in May. It was, however, forced to call for an emergency meeting to discuss how to manage the widening gap between peripheral (Italy) and core (Germany) bonds yields. Italian 10-year bond yields broke above 4% last week and its differential to its German peer hit 2.5% making it impossible for the ECB to implement a unified monetary policy. Higher borrowing cost in peripheral economies led to the European sovereign debt crisis more than 10 years ago with devastating economic consequences and something similar is developing this time around.
In the UK, inflationary pressure is aggravated by the effect Brexit has on the economy. Inflation in May stood at 7.8% but is expected to rise over 11% by October. The Bank of England increased rates by 0.25% and further hikes are anticipated in months to come. The country’s economy contracted in March and April and the OECD expects the UK to be the laggard amongst the G20 nations next year.
Stuttering global economic growth will have a profound impact on oil consumption. We have expected resilient oil prices through the summer due to pent-up demand and scarce product supply. It is still a realistic option. It seems that after Friday’s price fall triggered by growing worries about inflation attention shifted back to supply issues and the oil complex started its recovery led by distillates. It should limp through the summer relatively unscathed and even supported by healthy consumption, but prolonged weak economic performances should ultimately take its toll on demand toward the last quarter of the year. The global economy is currently on the Highway to Hell. It will take time until it starts climbing the Stairway to Heaven and in the meantime, oil will not be able to defy the financial gravity infinitely.