Ukraine: War, oil, inflation and monetary policy
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Ukraine: War, oil, inflation and monetary policy

The hottest topic in the economic and investment world today is the war between Russia and Ukraine, following Russian President Vladimir Putin's decision to launch a full-scale invasion of the neighbouring country on Thursday. As the conflict is escalating quickly, we will consider the possibility of a full-blown war in which Russian and NATO forces would fight, impacts on the economy, inflation and global monetary policy.

Mr Putin for years has been warning the West about the consequences if Ukraine is admitted to the North Atlantic Treaty Organization (NATO). The country first sought entry in 2008 but still has a long way to go to meet the terms. But in June 2020 it was declared an "enhanced opportunity partner", a possible stepping stone to membership.

Developments in the next month in Ukraine will be critical. For Russia, the priority will be to occupy Kyiv as quickly as possible. There are already reports of tanks and troops in parts of the capital, and political observers believe Russia wants to remove the current government and replace it with pro-Moscow figures.

For the West, the priority will be to implement the most painful economic sanctions possible against Russia in the near future. This would include barring Russia from the Swift global financial system, cutting access to all forms of dollar transactions, but this is a "nuclear option" that European nations and the US are reluctant to exercise.

In the meantime, the focus will be on banning transactions by leading Russian financial institutions including Sberbank and VTB bank; a total ban on exports to, and imports from, Russia; and sanctions on financial transactions against President Putin and/or many of his cronies. So far, only the banking ban has been imposed by the US.

If the US and European allies collectively implement the measures listed above, we believe the Russian economy will be affected within two or three months, given that imports account for around 20% of its GDP.

We believe that as the development of the war and sanctions progress, Mr Putin will open talks with the West, especially the United States. This could lead to two possible scenarios:

The first scenario is that the US and the West provide more military aid to Ukraine as fighting intensifies. At the same time, NATO may speed up the process of accepting Ukraine as a full member. In this case, the military conflict would be prolonged, which in turn would increase domestic political pressure on Western powers. We view that this has a 20% chance of probability.

The second scenario is that Western countries pressure Ukraine to withdraw its NATO membership bid. They would also recognise the Luhansk and Donetsk regions in eastern Ukraine as the independent states Mr Putin claims they are, in exchange for Russia's withdrawal of troops from Ukraine.

On the other hand, the Russian army may capture Ukrainian President Volodymyr Zelenskyy and force him to step down, while calling for new elections to replace him with a pro-Russia leader. We view that this has an 80% chance of probability.

Although we see a full-blown war between Russia and the West (scenario 1) as highly unlikely, we still believe the situation is extremely uncertain.

As for the effect of a full-blown war on the world economy, the key impact will be on the price of commodities, especially fuel. Russia is the world's largest exporter of natural gas and the second largest exporter of oil, while also a major exporter of aluminium and copper. Ukraine and Russia together account for 30% of the world's wheat exports. Prices of these commodities would skyrocket if the West and Russia became locked in combat. Oil could reach $120 per barrel, while aluminium may rise to a record high.

Our sensitivity analysis has found that, based on fundamentals, the current Brent crude price should be around $75 a barrel. This is because the current spread between world oil demand and supply is about 2 million barrels per day -- the same as in the third quarter of 2021. Under our model, the equilibrium price should rise only modestly from the third-quarter price of $73.50, to $75. The current price of $100 thus reflects a "war premium" as well as speculation on rising prices.

If oil is around $75, we calculate US inflation could be around 4.5% and Thai inflation around 1.6%, with the consumer price index high at the beginning of the year before declining towards the end of the year as the baseline returns to more normal.

But if the Ukraine conflict is severe and prolonged but does not reach a full-blown big-power war, oil could rise to an average of $90-100 a barrel. That would lift US and Thai inflation as high as 6.9% and 3.1%, respectively, in the worst-case scenario.

Given those high levels of inflation, the Federal Reserve and the Bank of Thailand will need to raise interest rates. At present, we believe the Fed will make five increases this year while the BoT will keep its policy rate unchanged. But in the worst-case scenario, the Fed may have to lift its benchmark rate seven times, 25 basis points at a time, to 1.75%, while the BoT may have to raise its rate by 50 basis points to 1% by year-end.

Apart from raising rates, the Fed may have to carry out so-called quantitative tightening (QT) -- reducing its balance sheet -- which will result in rising long-term yields for benchmark 10-year US Treasury bills. At present, we believe the long-term yield will be around 2.3% at the end of the year, compared with just under 2% now.

If the Fed raises rates to combat inflation expectations, the pace of QT may have to increase as well. If the 10-year yield, which reflects the private sector's financial costs, is higher than the pace of economic expansion, which reflects earnings growth, the US economy would be at risk of a recession.

However, if the tension between Russia and Ukraine subsides, and/or other events occur, such as restoration of the nuclear agreement between Iran and major world powers, oil prices may ease, which lessens the probability of high inflation, interest rate increases and an economic growth decline.

In summary, although current economic and monetary policy outlooks do not include the hypothesis of a full-blown war between Russia and the West, there is still a high probability that there will be an economic downturn next year.

But if the war intensifies and the economy suffers, it will be even more difficult for the Fed to cut interest rates or resume quantitative easing to stimulate the economy due to higher inflationary risks. Hence, we view that global economic and investment risks are relatively high going forward.

Piyasak Manason is senior vice-president and head of the wealth research department at SCB Securities, email

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