Ukraine invasion could fuel inflation, putting central banks in delicate position as they look to hike rates

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Russia’s invasion of Ukraine is pushing up global energy and food prices, adding to inflationary pressures and putting central banks around the world in a delicate position as they embark on a much-anticipated rate hike cycle.

Russia is one of the world’s largest oil and gas producers, and both Russia and Ukraine are major food exporters, together accounting for more than a quarter of global wheat exports. Expectations of major disruptions to those exports have already begun to shake global commodity markets, pushing up prices and adding fuel to fears about spiralling inflation.

“Watch the food inflation story. Russia is a global commodity superstore, they are not a gas station. Their ability to inflict serious harm to consumers across the world is substantial,” Helima Croft, Royal Bank of Canada’s head of global commodity strategy, said in an interview.

Countries around the world are already struggling with the highest inflation in decades as a result of disruptions caused by the COVID-19 pandemic. A sustained surge in commodity prices could add to the pain consumers are feeling at the grocery store and gas pump.

This puts central banks in an uncomfortable spot. If higher food and energy prices push up already rising inflation expectations, central bankers could be forced to raise interest rates aggressively to keep expectations anchored. At the same time, calculations around rate hikes could become more complicated if the war in Ukraine drags on and starts weighing on global economic growth.

In a volatile day of trading, the price of West Texas Intermediate crude oil shot past US$100 a barrel on Thursday for the first time since 2014, before ending the trading day around US$93. The price of natural gas in Europe rose sharply on fears that supply could be choked off, with the benchmark Dutch futures contract up more than 40 per cent. Russia supplies nearly 40 per cent of Europe’s natural gas, and several critical pipelines run through Ukraine.

Meanwhile, the price of wheat futures contracts in the United States was up around 5.5 per cent by Thursday afternoon.

“If higher prices are sustained, this will push inflation much higher through this year not just in Europe but globally,” Rich Kelly, head of global strategy at TD Securities, said in a note to clients.

“Central banks had been counting on easing energy prices through [the second half of 2022] to pull inflation back toward target; today’s developments could spell an end to those hopes,” he wrote.

The Bank of Canada’s latest projection, from January, shows the rate of inflation remaining close to 5 per cent until the middle of the year, and then declining to around 3 per cent by the end of the year. That estimate, however, is based on US$75 for a barrel of West Texas Intermediate crude, much lower than the current and projected price of oil.

Economists at Bank of Montreal estimate that every US$10 rise in the price of oil boosts consumer price inflation in Canada and the U.S. by around 0.4 percentage points. If oil prices hold at current levels or move higher, “this factor alone could bump headline inflation by roughly 0.6 percentage points,” BMO chief economist Douglas Porter wrote in a note to clients.

“Complicating matters is that the Canadian dollar has not benefited one iota from the rise in oil prices in 2022, in contrast to the previously tight relationship between the loonie and crude. While good news for domestic producers, this implies that Canadian consumers are facing the full force of higher global oil prices, unlike earlier crude price spikes,” Mr. Porter wrote.

The Bank of Canada is widely expected to begin raising its policy interest rate next Wednesday for the first time since it cut rates to near zero at the outset of the pandemic. Officials have indicated that the bank expects to raise rates several times this year.

The conflict in Ukraine is unlikely to push back the first rate hike, analysts say. But central bank officials will have to be cautious as they map out the coming rate hike path.

Jennifer McKeown, head of the global economics service at Capital Economics, said that central bankers may be at a tipping point, where worries about inflation will have to be balanced against fears of an economic downturn.

“It won’t stop the [monetary policy] tightening that’s already planned, but it could delay it a bit,” she said in an online presentation on Thursday.

The U.S. Federal Reserve, the world’s most important central bank, is still expected to start raising interest rates at its upcoming policy meeting on March 15. At the same time, markets are no longer pricing in a high likelihood that the Fed will start its rate hike cycle with a 0.5-percentage-point increase instead of the usual 0.25-percentage-point increase.

“Ultimately, developments overnight in Ukraine are likely to cool G10 central banks’ hiking ambitions a little,” Mr. Kelly of TD wrote.

“While we still expect hikes from most central banks in the coming months … worries about weaker demand could dampen prospects of 50 basis point hikes in favour of a more cautious approach, and may slow the pace of subsequent hikes this year,” he said.

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