The people of Ukraine have shown extraordinary courage in the face of a terrifying threat from Russia. From the first attack on February 24, the Ukrainians resisted, even pushed back, Putin’s persistence in controlling the region. In Putin’s worldview, Russia must regain its dominance on the world stage, even if that means ruthlessly slaughtering mothers, babies and scores of innocent civilians. Yes, it is tragic. Another element of Russia’s attempt to take over Ukraine is the economic fallout. Certainly, the Russians will feel the brunt of this given the sanctions imposed on the country and Ukraine will also suffer greatly. Europe will also feel economic hardship as it depends on Russia to meet its energy needs. Could there be a ripple effect in America? Is a US recession possible? In short, yes, it is very possible.
Europe’s energy crisis
According to the US Energy Information Administration, Europe is a key destination for Russian energy exports. In 2021, Russia exported 49% of its crude oil and condensates and 74% of its natural gas to Europe. In short, Europe is Russia’s biggest energy customer. Most of the crude went to the Netherlands, Germany and Poland, while the majority of Russian natural gas went to Germany, Turkey, Italy and France. Yes, Europe is very dependent on Russia for its energy and turning it off is not an easy task.
Europe gets almost 25% of its energy from natural gas and the cancellation of the Nord Stream 2 gas pipeline, which would link Russia to Germany, would affect its future gas imports. In retaliation, Russia discussed stopping the flow of natural gas to Europe. Clearly, energy is a major concern for Europe, one of the most energy-dependent regions in the world. As a result, expect the European economy to slow down, which could have a negative effect here in the United States.
Fallout in the United States
A slowdown in Europe due to the war in Ukraine is only one of the factors that will boost US economic growth. Fed policy is another. How will the war affect the American economy?
There are many multinational corporations in the United States that derive revenue from Eastern Europe. If the European economy slows down, many businesses could experience a drop in revenue. Which companies are most at risk? Here are a few based on income (as a percentage of total income) from the conflict zone. The list includes Philip Morris (8.0%); PepsiCo
Fed policy is another key determinant of the US economy. After nearly 14 years of zero rate policy and two years of extreme monetary stimulus, the Fed announced the end of both. At its last meeting, the Fed raised its short-term interest rate by 0.25%, marking the first time since the housing crisis that it was above zero. With 5-7 more rate hikes to come, plus the removal of excess monetary stimulus, the Fed is trying to rein in inflation.
Why is inflation so high? Inflation occurs whenever demand is significantly greater than supply. This time, inflation rose due to Covid-related supply chain disruptions and pent-up demand. It is also strongly affected by rising energy costs such as the price of oil, natural gas and gasoline as well as rising food prices. Ukraine and Russia provide around 25% of the world grain supply. Cereals are used to feed livestock, farmed fish, chicken, etc.
In switching from an accommodating monetary policy to a tightening policy, the Fed will have to be extremely careful not to go too far and cause a recession. For example, if the Fed continues to tighten, while supply chain issues and the war are resolved, the US economy may well end up contracting. The Fed can only influence the demand side of the inflation equation, so it must watch the supply side very closely. Therefore, if the war in Ukraine ends and the Covid-related supply chain issues are resolved and the Fed continues to tighten, a recession is a very good possibility. Although most economists don’t expect it before 2023.