As Russia’s invasion of Ukraine enters the end of its first month, knock-on effects are being felt across multiple industries. British Steel recently announced an unprecedented 25% increase in its prices in the face of “soaring costs”. Other European Steel makers are affected in the same way, and unless there is a rapid reduction in the price of electricity and other costs, we are likely to see similar moves from more companies in the industry.

The UK government has also asked UK brick makers to prepare to slow production in case the shortage of energy necessitates energy rationing. High-usage industries, such as the brick making industry, are often the first to be affected by energy rationing, as the priority shifts to keeping the power on for domestic consumers. This is likely to have a further knock-on effect on the construction industry as housebuilders and construction companies are heavily reliant on brickmakers.

The root cause of both stories goes back to the awful scenes we see being played out in Ukraine. However, even if peace broke out tomorrow it is naïve to assume that Russia’s supply of natural resources would return immediately to pre-war levels. Many of these additional supply chain shocks are likely to remain, even if below current crisis levels.
Inflation at inflection point
The key problem for central bankers is that much of the increase in price pressures that we have seen since the post pandemic recovery exposed problems in the supply chain. These have now gone on for a significant period of time, and this second supply chain shock from the Ukrainian crisis is likely to further embed inflation expectations in the minds of consumers, manufacturers, and workers.

The surge in energy and other prices that we are currently experiencing is unlikely to be repeated in 12 months’ time, so some of the astronomical year-on-year data prints for both headline and input prices will ease. However, the debate around inflation and central bank policy is centred on whether longer term inflation expectations are rising and therefore whether central banks feel they are losing control of those expectations and therefore of inflation itself.

The expected 5-year forward expected inflation rate for Europe is now back at levels not seen since 2013, while US 5-year forward expected inflation is at levels not seen since 2014. It is important to bear in mind that European 5-year forward expected real rates are -1% and US forward real rates are -0.45%. This highlights the dilemma for the Fed and other central banks – they are facing back-to-back supply shocks, delivered (in economic terms) in double quick time. This comes at a time when many in the ECB (and other central banks) realise their ability to change that supply dynamic is limited through monetary policy. However, monetary policy is all they’ve got and they can’t just sit back and do nothing as the current level of negative real rates will compound the problem.
Will real rates rise?
So how far might real rates go to counteract this problem? Looking back to 2018, the Fed believed they had an inflation issue brewing, and certainly wanted to normalise monetary policy so they moved 5y5y real rates to 1% before the market realised there wasn’t an inflation problem, and the Fed was purely engaging in a policy error. Now given the current economic backdrop many would argue that if the Fed raise rates to the extent that some are forecasting, they would be engaging in a repeat of that policy error.

However, regardless of whether or not that is correct, we are already on the path to positive real rates and may experience something similar to the levels seen in 2018. The process will take 12-18 months before we can assess whether that policy shift is justified or not, but for us for the Fed to do nothing is not really an option.

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