Ukraine could turn boomflation into stagflation

Russia's invasion of Ukraine creates a new wrench in the gears of the global economy that will simultaneously worsen inflation pressures and damage growth prospects. That makes it a stagflationary shock, essentially making things worse on all economic fronts at once.

Why it matters: So far in the pandemic recovery, major Western economies have had boomflation — strong growth with high inflation. What we may face now is the kind of inflation that could undermine the "boom" part and worsen the "flation" part.

• It's not the kind of economic disruption that can be fixed with clever use of fiscal or monetary policy. It's all pain, no gain. The effects are likely to be most severe in Europe, where economic ties with Russia and Ukraine are deepest.
• But through the deeply interconnected global financial and commodity markets, the ripples are set to spread worldwide.

State of play: The invasion sent commodity prices soaring and global stock markets and bond yields plunging Thursday (initially, at least), continuing moves that had been underway for weeks.

• But financial market prices don't tell the full story. They remain highly volatile, as traders react to incoming headlines from the battlefield and from the policy decisions in Washington and European capitals.

Between the lines: What we do know is that there will be continued and escalating financial sanctions on Russia, damage to Ukraine's export industries, and high risk of further ripple effects from both physical and cyber-attacks.

• All of those amount to a negative supply shock — meaning that the productive capacity of the world economy is simply lower than it was a few weeks ago.

Higher energy prices — already evident in commodity markets — directly feed into higher inflation, but the risks are more sprawling and hard-to-calculate than that implies.

• The risk of disruption to Western European energy supplies and transportation networks, and the potential for cyber attacks contributes to the strain on global supply networks that have already been at their breaking point.

In European countries with close economic ties to Ukraine and Russia, the disruption could lower appetite for business investment and consumer demand. Who wants to build a new factory in Romania when warfare is taking place just down the road?

The United States is relatively insulated from the immediate economic damage, with its location an ocean away, strong domestic energy production, and robust (maybe too-robust) consumer demand.

• For the U.S., the direct impacts of the conflict are likely to push already-too-high inflation even higher. Those effects should on their own be short-lived, but the timing means they risk further entrenching Americans' rising inflation expectations.
• Still, the Federal Reserve is likely to view the crisis as reason to move more gingerly in its monetary tightening campaign, as economic uncertainty grows, based on comments from several Fed officials this week.

The bottom line: Usually, geopolitical strife represents a short-term blip for financial markets and a buying opportunity for the gutsy. That could yet be the case with Ukraine, but the range of possibilities is ominous.