Introduction

Commodity supply disruptions from the Russia/Ukraine war are resulting in higher commodity prices. Australian flooding across the east coast also means the likelihood of higher prices for fruit and vegetables in the near-term. In this Econosights we look at the upside risks (to an already elevated inflation profile) for Australia and other major economies in 2022.

Downgrade to global growth forecasts

We have downgraded our 2022 global GDP growth forecast by 0.4 percentage points to 4% because of the war between Russia and Ukraine. While these two countries make up a small 3.5% of global GDP (in purchasing power parity terms) there is some negative flow-on effect to the larger (in GDP terms) surrounding European countries (especially Germany which is Russia’s third largest export market) through production impacts, falling consumer confidence and higher commodity prices.

A drawn out conflict that curtails Russian oil and gas supplies to Europe would mean that GDP would need to be revised down further from here. But hopefully the situation can be resolved soon or at least is contained. In the longer-term, rebuilding after the war could have a positive impact on GDP growth.

Global growth of 4% per annum is still a solid and above trend growth rate and the other factors driving global growth higher (a build up of consumer savings over the pandemic and the further re-opening of global economies and international borders) remain intact.

Commodity prices surging across the board

Commodity prices were already elevated in 2021. Supply disruptions in some markets (like oil and gas) along with higher demand from the global re-opening were the main factors lifting prices. The Russia/Ukraine war has added further upward pressure to commodity prices because of the concern around disruptions to production and exports and increased demand for heavy machinery used for warfare. Both Russia and Ukraine are key global commodity suppliers. Russia accounts for 17% of global gas exports and 12% of global oil exports (a top 3 global exporter).

Natural gas prices are up by up to 127% year to date in Europe, after huge gains in 2021 (up by 260% on average over the year). There are a few reasons for the surge in prices: 1/ lower-than-usual gas storage levels in Europe which led to a big lift in European gas prices 3/ a colder than expected winter in the Northern hemisphere increased demand and 4 /weak renewable power generation in Europe (with many European countries like Germany now relying heavily on renewable energy).

Difficulties in gas transportation and influence from domestic regulators results in diverging gas prices between countries. US gas prices have not risen as much compared to Europe (prices are up 29% year to date in the US). And Australian gas price rises have been lower compared to both the US and Europe because of our own domestic source of gas and from milder temperatures which reduces the need for heating. Utility prices in Australia were actually declining in annual terms for the majority of 2021.

Oil prices were rising in 2021 from a normalisation in demand for air travel and supply constraints in the oil market and have shot up to around $110/barrel, the highest level since mid-2014.

These increases in commodity prices will be passed through to consumers and businesses. Energy costs will increase and petrol prices will rise. Europe’s direct reliance on Russian gas (the EU imports around 30% of its gas from Russia) means European households and businesses will be hit the hardest.

So far, sanctions on Russia have excluded energy. But, while the war continues, the uncertainty around supply will keep commodity prices high. There is also a big risk of Russian gas supply becoming completely cut off from Europe if the conflict escalates which would cause even further price rises.

Other commodity prices are also surging. Metals prices like iron ore, nickel and aluminium have all risen sharply along with coal and agricultural commodities including corn, soybeans and wheat. This means the risks for higher food prices which would cause the most problems for developing and poor countries. Sanctions on Russian airlines and shipping companies will add further pressure to supply chain, which are already strained.

The increase to headline inflation from these factors will initially be larger than for core inflation, But the longer that the conflict goes on, the more that core inflation will also be impacted. In Europe, we estimate that higher commodity prices will add 0.6 percentage points to headline inflation over the year to June, taking annual growth in headline inflation above 6% per annum.

For Australia, higher commodity prices will add around 0.3 percentage points to headline inflation in the March quarter but we also need to include the impacts from the floods.

Flooding in Australia

Current Flooding across the east coast of Australia (with the largest impacted areas in south-east Queensland, northern NSW and Sydney) hits consumer spending, agricultural production and exports. There can also be a temporary hit to inflaiton. From historical experience, flooding causes short-term spikes in fruit and vegetable prices from the supply disruption. Hopefully the current floods are less severe than the 2010/11 floods which lasted from late November 2010 – January 2011 and covered much more of Australia disrupting even mining production and exports. But we are still expecting higher fruit and vegetable prices to add 0.2 percentage points to headline inflation in the March quarter. Because we are in the last month of the March quarter, there could also be a flow on to the June quarter.

There will also be a disruption to exports and we expect a 0.1 percentage point hit to March and June quarter GDP from lower spending and exports. But rebuilding later in 2022 will provide a boost to second half GDP growth so for the year as a whole we have not changed our expectation for GDP growth around 4.5%.

Implications for the central banks

In Australia, the total inflation impact from the Russia/Ukraine war and the floods will add 0.5 percentage points to March quarter headline inflation and 0.2 percentage points in the June quarter from lingering high commodity prices. This means that we expect annual headline inflation growth of just over 5% in June and around 4.5% over the year to December. Trimmed mean inflation is expected to be 4% over the year to June and 3.6% over the year to December.

While one-off spikes in headline inflation can be looked through by central banks, the risk with the current situation of high and rising commodity prices and potential further trade-related supply disruptions is occuring at a time of already heightened inflation. Global central banks will be cautious about hiking interest rates while financial markets are experiencing large volatility. Expectations of a 50 basis point rate hike from the US Federal Reserve in March have been wound back to a 25 basis point hike. But, the Russia/Ukraine war will not stop central banks from hiking interest rates, it could just mean that the rate hike cycle will be extended if central banks choose to proceed more patiently. Again, a lot depends on how long the conflict lasts.

Because of the further boost to underlying inflation in Australia, our view on the Reserve Bank has changed and we now expect the first rate hike in June (previously August) as March quarter inflation and wages data is likely to be much higher than the RBA anticipates. After June, we expect two more rate hikes in August and November, leaving the cash ratate at 0.75% by the end of the year.