Capital Ideas^TM

Russia’s military aggression against Ukraine, which has become Europe’s largest ground war in generations, has impacted millions of people and triggered a large-scale humanitarian crisis as vulnerable Ukrainians take shelter or flee their homes. The intensification and spread of the conflict is deeply troubling and is having a devastating impact on those people caught in the crisis.

This article focuses on potential market and economic implications of the conflict

Fiscal response: I expect European governments to use fiscal policy to support their economies in the face of the shock. We could see other governments adopting similar approaches to France, which has effectively pegged the price of gas for domestic consumers. While this is expensive, it would mitigate the impact of higher energy prices on inflation and damp the squeeze on real incomes. Governments might also consider compensation for businesses that are big users of gas.

As in the pandemic, national governments are likely to lead the fiscal response. Both Germany’s Scholz and Italian Prime Minister Mario Draghi spoke about the need for European solidarity. Given the potential scale of the shock, the EU will likely suspend its fiscal rules again this year, and there might well be discussions about extending or enlarging the size of the Recovery Fund (the EU’s collective fiscal response to the pandemic). As the EU considers its energy security and energy transition, it could conclude that such spending requires more fiscal integration across the bloc.

Central bank policy: The ECB and the Bank of England must decide whether to press on with their intended monetary policy tightening. A substantial energy-induced inflation shock creates an acute policy dilemma. While central banks would typically look through such a terms-of-trade shock, they will be aware of the lessons of the oil shocks of the 1970s. I expect both central banks to proceed cautiously given the extreme uncertainty around the scale and duration of the current shock.

Gas supplies: A further escalation of tensions could encourage Russia to restrict the supply of gas to the EU, or the EU could impose restrictions on gas imports. The EU has stored gas and could increase imports of LNG to see it through to the spring. Even so, in a worst-case scenario, the big users (Germany and Italy) might be forced to ration gas to heavy industry, inflicting a further economic shock. The United Kingdom has relatively low supplies of gas and imports primarily from Norway. But the U.K. is exposed to higher prices and could suffer if Norway diverts supply to the EU.