The Russian invasion of Ukraine has caused immense human suffering. In addition, historical evidence suggests that this can threaten financial stability throughout the global economy through its potential impact on many aspects of economic activity, especially inflation. For instance, immediately after World War II, inflation shot up to 20%- aggravating the effects of the war.
Global economic prospects, therefore, look bleak due to Russia’s invasion. This crisis is unfolding even as the global economy has not fully recovered from the shocks of the pandemic. Experts indicate that the war's impacts will spread far and wide, increasing price pressures and intensifying major policy difficulties. In this article, I attempt to decode the impact of war on inflation while discussing some policy implications.
What is inflation? Why is it a concern today?
Inflation refers to the rise in the prices of goods and services in the economy. Owing to this rise in prices, the purchasing power of each currency unit decreases. The change in purchasing power impacts the cost of living. High inflation leads to a high cost of living, thus, slowing economic growth. Currently, the global economy is going through a period of revival after being hit by Covid-19. In this scenario, it is crucial that households spend more, which requires the prices to be stable. However, the Russia-Ukraine war holds the potential to derail the economy by pushing the prices of basic commodities up. Thus, it is vital to address this issue as soon as possible.
High inflation- Not a recent phenomenon
Inflation was high even before the calls for the Russian invasion began. Focusing on the war may make one miss this crucial detail. As Steve Rattner, in his opinion piece, says- the argument given by American policymakers that the primary reason for inflation was that supply chains were cut off during Covid-19 is misleading. One of the reasons is that most of the supply problems in the United States of America are homegrown. Americans were spendthrift when Covid-19 faded, and this consumption was fueled by massive sums of government rescue help and significant underspending by consumers during the lockdown period. There has also been an unanticipated shift in what consumers are buying. Many people are still fearful of the virus and travel is sluggish: resultantly, a large portion of spending has shifted to durable goods like cars, electronics, and construction materials for housing - all of which have limited production and distribution capacity.
In economic terms, this scenario can be called ‘too much money chasing too few goods.’ Because of a surge in demand for these goods, the scenario leads to a supply shortage and higher prices. For instance, the extreme shortage of semiconductors has gained a lot of attention. Manufacturers, despite breaking the previous year's record and providing an astounding 1.15 trillion chips in 2021, the deficit persists. And when semiconductors are in short supply, auto companies curtail production (semiconductors are a significant part of modern-day vehicles) and prices rise- pushing up inflation.
Wars and Inflation- an uncanny connection
Now that we have an overview of the situation concerning inflation before the war, let us now dive into the war’s effects. Trends show that wars like the Vietnam War and the Russian Revolution have been a precursor to rising inflation. And it is not different this time as Russia’s invasion of Ukraine threatens to tilt economic forces towards higher inflation. But why does war typically cause a rise in inflation?
Firstly, the needs of the civilian economy are a massive burden in themselves, adding to that in the form of military equipment to wage war is futile. It unnecessarily increases demand and puts pressure on the productive capacity of the economy. Thus, there will be chances that this demand exceeds the capacity, leading to inflation.
Secondly, when two powerful countries are at odds, international trade and supply chains are frequently disrupted. Great Britain, for instance, blockaded the continent of Europe in the early 1800s to deny Napolean of resources because of which international trade suffered. Today, the world relies on sanctions instead of hard blocks, which we are seeing even in the present with Russian supply cuts. Countries that do not have access to these imports, therefore, naturally suffer from inflation as they have been cut off from a good that was available before through imports (the dearth of supply raises prices).
Thirdly, the governments may occasionally resort to measures like printing money in order to finance the war. They may also keep interest rates low, encouraging spending, and allowing the government to use the increased money flow in the economy to finance the war. However, this increased public spending leads to an increase in prices (due to increasing demand), having the potential to cause inflation in the long run.
What can be the way forward
As discussed before, one of the most natural reactions for a government during a war is to lower the interest rates to increase spending. However, this does more harm than good to an economy. For instance, in the 1960s, the USA funded the Vietnam War by keeping interest rates low, hurting the US economy in the long run. Thus, the primary aim of governments in these situations should be to maintain stable prices over the long run. The role of the central banks becomes crucial here. Central banks like the Federal Reserve (USA) and the RBI (India) control the interest rates. They must form their policies after taking into consideration factors that may indirectly hurt the economy. In this case, maintaining interest rates that do not swell up inflation too much.
(Written by Raghav Bansal and Edited by Prakhar Singhania)