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The Uncertainty of Conflict

Unthinkably, – a major conflict has arisen between Russia and Ukraine, with the former invading the latter.  An act of war. Though the direct participants face the maximum impact, consequences are already rippling throughout the rest of the world.  There are no playbooks to predict how war can develop. But wars are not new, unfortunately, and history can demonstrate patterns of their effects.

It’s been eight decades since the last major global warfare, punctuated by smaller regional and bilateral wars. 30 years ago, the globe seemed united by a common desire for peace and prosperity, but that optimism now seems to have faded. While nations strengthen themselves and turn inward, prosperity will remain a distant dream for millions for a while.

The economic costs of war are significant: human tragedy, destruction of infrastructure, and massive displacement of working populations. They are exacerbated by shortages and instability, which generally lead to inflation. From certain angles, a conflict appears to benefit businesses by increasing demand, employment, innovation, and profitability – especially when the war occurs in other countries. What are some of the possible impacts the Russian-Ukrainian war could have on economies, interest rates, and behaviours?

War and inflation

War can cause inflation, which causes people to lose savings, increase uncertainty, and lose faith in the financial system. For example, during the American Civil War, the Confederacy experienced financial struggles. So they started printing money to pay the soldiers. But when they created money, its value fell, hurting all income earners. Those saving at a middle-income level were the hardest hurt by the resulting higher inflation.

During WWII, the US had severe inflation due to increased government spending and labour shortages. Cost-push inflation occurs during wartime due to shortages of products and services and increased raw resource prices such as oil. Pricing regulations and rationing slowed WWII inflation.

Most experts agree that rising crude, gas, and coal prices will ignite an inflationary firestorm that was already stoked by a jump in demand during the global epidemic, which was accompanied by the increasing scarcity of nearly everything. Because Russia is a key exporter of commodities such as food and fuel to the world, its exclusion from global trade flows will directly benefit net importing nations in terms of their national balance sheet, assuming sanctions continue to hold.  All consumables, from production to transportation, rely heavily on fuel. Costs will be passed on to customers if they rise. For example, the 1990 Gulf War raised oil prices. Prices climbed from $21 a barrel in July to $46 a barrel after the invasion.

War and Interest Rates

Increased defence spending (particularly during wartime) creates incentives to produce fiat money, which tends to generate inflation and high prices. Additionally, wars generate a scarcity of items currently available for non-military use in comparison to the quantities available in the future. Individuals’ subsequent attempts to smooth their consumption across time create an excess demand for current commodities, resulting in an increase in the interest rate.

The most essential actions taken by the Federal Reserve System throughout world war II were to stabilise financial markets and to help cut interest rates on funding the enormous fiscal deficits associated with active participation of the US in the war. The System conducted limited open-market purchases in 1939, just before the outbreak of World War II, to affect the yields on short-term government bonds. The purpose was to stabilise short-term finance markets and avert market chaos at the beginning of the war.

In the current situation of the Russia-Ukraine war, Philip Lowe, the Reserve Bank of Australia’s governor, has made it clear that the RBA will not raise rates until inflationary pressures are adequately addressed. Wages may not keep pace with inflation for a long time because many Australians are tied by Enterprise Bargaining Agreements and other contract arrangements.

There’s little doubt about it: higher interest rates are on the way. However, the invasion of Ukraine may slow the rate of rate hikes rather than accelerate them up. In fact, rising energy and food prices (almost a quarter of the world’s wheat supply comes from Russia and Ukraine) are expected to have a negative impact on the global economy. As a result, interest rates are expected to climb at a considerably slower pace this year than were expected to.

War and globalisation

For nearly a century, trade expanded at an average annual rate of 3%. This rate of increase boosted exports from 6% of global GDP in the early nineteenth century to 14% on the eve of World War I. Between the world wars, the financial markets, which remained connected through a worldwide network, contributed to the further breakdown of the global economy and its interconnections. The Great Depression in the United States brought an end to South America’s boom and sparked bank runs in many other regions of the world. In 1939-1945, another world war ensued. By the end of World War II, trade had fallen to 5% of global GDP, a level not seen in more than a century.

In light of the COVID-19 pandemic, global supply chain flaws were exposed, leading to severe shortages and price increases. The supply of numerous essential commodities is now threatened by sanctions on Russia, raising concerns about the future of the global economic order as a whole.

The largest supply shock since the Yom Kippur War in 1973 is predicted by experts. Global supply networks will be affected in unexpected ways as we watch the reshaping of the international order. Global economic bifurcation is a serious threat from the Russia-Ukraine conflict if its international consequences continue spreading. Geopolitical alliances, energy flows, currency systems, and trade lanes might separate if the conflict continues. Commodity prices have more than doubled from pre-pandemic levels, with crude oil, coal, and gas prices driving the increase according to the HWWI Index.

Modern warfare, unlike the wars of the past, seems to have a deeper impact on the world. We are all in an economic war and the recovery rate completely depends upon the actions of a country’s leader. Even though there are several predictions by economists, the future remains uncertain.