Risk of a big economic shock from Ukraine war is rising fast

The prospect of a significant economic shock to households and businesses is increasing, with no end in sight thanks to the war in Ukraine. Soaring wholesale energy prices are the clearest signal, underlined by the issue of whether trade with Russia for gas and oil can – or should – continue. In Ireland , if current prices are maintained, petrol will rise before long to €2 a litre and there will be more big increases in home energy bills.

The crisis also threatens a wider hit to inflation, with commodity prices for food under severe pressure too and a likely hit to confidence and economic growth. For now, all depends on the course of the invasion and the accompanying politics.

1. Energy price squeeze:

The clearest channel through which households and businesses will be hit is higher energy prices and here fears are rising. As the economic sanctions bite, the US and EU have tried to ringfence energy trade for now, for example exempting banks most involved in energy trade from exclusion from Swift, the payments system.

However energy markets are nervy that energy supplies could get affected as Russia gets shut off from the world financial system and the value of the rouble takes a heavy hit. This has pushed oil prices sharply higher, with Brent crude trading close to €120 a barrel early on Thursday. Buyers were shunning Russian oil after the announcement of sanctions – partly due to shipping and finance fears and difficulties in getting insurance. The bulk of Russian oil supply is not being sold, leading to a scramble for oil from other sources. A western embargo on Russian oil has not been ruled out, but for now the market is putting in place something similar.

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Futures prices on gas markets have soared, reaching over €190 per megawatt hour on Wednesday and on Thursday trading early in the day at €180. To put some context on this, gas prices were under €20 at the start of 2021 and have traded between €20 and €30 for many years. They were around €80 at the turn of the year. While Russian gas continues to flow to European markets, a risk premium is now built in, with traders fearing supply disruptions.

If these kinds of prices are sustained, then households are in for a further surge in home heating costs and the costs of filling up a car. Petrol prices, now generally around €1.80 to €1.85 a litre, will break through the €2 barrier if wholesale prices hold at or near current levels. The extent of the likely rise in the price of heating a home is hard to predict, but another sharp jump higher will happen if anything like current wholesale prices are maintained – and with gas a key fuel for making electricity in Ireland, prices here will also be affected.

Irish businesses are big consumers of gas – relying on it for some 40 per cent of their energy – so they will be hit too.

This will inevitably put pressure on governments all across Europe, including here to react to try to give some protection to consumers and businesses , with ministers referring recently to EU discussions on the issue.

2. Energy security:

The EU and US have cut off the Russian central bank’s access to much of its foreign exchange reserves, thus compromising its ability to support the rouble and last out a longer conflict. But by designing the sanctions so that the EU can continue to buy Russian oil and gas they are still providing president Vladimir Putin’s regime with significant foreign currency though another route, financing Russia and its war effort. The Russian economy is still being severely damaged, but can the EU continue to buy Russian energy if the conflict continues to worsen?

Russia supplies up to 40 per cent of EU gas imports – though the total is less at the moment on some estimates. In a blogon the subject, researchers from the Bruegel think tank pointed to the huge challenge which the end of Russia gas supply would mean for Europe, including soaring prices, the need for an EU-wide efforts to coordinate new supplies from sources like LNG and measures to cut demand, including the possible need to ration supplies at some point.

Ireland is not directly reliant on Russian gas – we get around 30 per cent from the Corrib field and import the rest from or through the UK, to which Norway is a major supplier.But any sudden disturbance to Russian supply would tighten the whole market and threaten supplies across Europe, so we would suffer too.

3. Wider inflation:

Higher energy prices will directly push up inflation – and businesses will also in time push up costs to recoup. The Ukraine crisis is also sharply increasing pressure on food commodity prices. Russia and the Ukraine account for a third of the world's wheat, for example and are also key producers of other cereals like maize. Russian, meanwhile, is a major producer of ,fertiliser, aluminium and other key metals. Like the energy market, parts of the food and industrial input market may get gummed up, with supply problems and are already seeing much higher prices.

Focusing on the energy issue, an analysis in the recent Central Bank quarterly bulletin ( Box F) estimated that a doubling of import prices would add 2.7 percentage points to the Irish inflation rate in 2022, bringing it from 4.5 per cent to over 7 per cent. Certainly a big spike in the rate of inflation will now happen unless energy prices quickly retreat, which as of now looks unlikely.

4. Interest rates:

Central Banks look set to face a dilemma as inflation rises more quickly than anticipated but growth falls. There has been talk of the return of so-called “stagflation” – a combination of low growth and high inflation last seen during the oil shocks of the 1970s. For now, investors are betting that central banks will react by increasing interest rates less rapidly than had been anticipated. For Irish borrowers, this may mean that the start of an upward trend in interest rates, which had been expected to start late this year and gather pace in 2023, may be postponed. Senior ECB figures are suggesting a wait and see approach may be needed. It is too early to be definitive here, but having combated the Covid-19 shock, central banks may be called into action again. Rock bottom rates for Government borrowing may remain for longer than we had thought.

5. Growth shock

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The wider impact of all this depends on how the conflict plays out. But by hitting household income and business costs, the energy price shock threatens a significant hit to growth across Europe and in Ireland. For now, a lot of investment projects will be put on hold as the world watches what happens next.