The global economy was in a reasonably strong position in the early months of 2022. The omicron variant of COVID-19 had delivered a sharp but short-lived blow to activity and was in decline almost everywhere. As we had highlighted in our previous S&P Global Economics reports, the health and economic impact of each successive wave of the virus was diminishing. This reflected relatively widespread vaccinations, particularly in the advanced and middle-income economies, as well as governments, firms, and households learning how to manage and live with the virus.

While the observed pace of activity was strong, the economic recovery from the pandemic remained incomplete. Although the "Big Three" economies--the U.S., China, and the eurozone--had all regained their pre-pandemic output levels, they were still below their pre-pandemic paths. The gap between the advanced and emerging markets was wide, with many economies in the latter group likely to suffer lasting damage to their output.

The final piece of the early 2022 picture was the continuing rise in inflation. This was particularly the case in the U.S., where the Federal Reserve dropped the word "transitory" from its narrative and increasingly signaled that it would need to move aggressively to head off inflation pressures that appeared more domestically than externally driven, owing to energy and supply-chain effects. While the Fed's about-face reverberated through markets (although much of the expected action had already been priced in), the upside was that inflation pressures reflected a robust recovery, including the effectiveness--and perhaps over-effectiveness--of fiscal policy.

Meanwhile, however, the eurozone was feeling notably less pressure, despite an equally robust rebound. This is due to less demand-driven fiscal policy and a smoother recovery of the labor market that is containing wage pressures.

Impact From The Russia-Ukraine Conflict

The Russian invasion of Ukraine on Feb. 24 has dominated the macro narrative for the past month. Although the economic effects are moderate on balance so far, it is doubtful we have seen the full impact, and the risks are clearly on the downside.

We have identified the following four channels through which the conflict could affect macroeconomic outcomes:

Direct economic links to Russia and Ukraine.  Russian and Ukrainian production and GDP will both fall sharply as a result of the conflict. Any disruption of production will have direct effects on the trading partners of the two countries. These effects will likely follow a "gravity model," where the economies geographically closest will feel the biggest impact in terms of quantity.

Higher energy and commodity prices.  Price effects will matter greatly as well. The conflict has added fuel to the fire of already elevated energy and commodity prices. For instance, West Texas Intermediate crude had risen to $95 per barrel on the day the invasion started from $75 per barrel at end-2021, and since has made a quite volatile rise to around $120 in late March 2022. Energy and commodity price changes are net zero on one level, since every buyer corresponds to a seller and every importer corresponds to an exporter. But higher prices destroy demand because users spend more than producers.

Confidence effects.  These are indirect effects and less precisely measured. Lower confidence will make households more cautious and therefore scale back or defer their discretionary spending plans, including for big-ticket items, renovations, and vacations. This, in turn, will lead firms to dial back or defer capital expenditure plans. This decline in private demand will reduce growth.

Chart 1a

Chart 1b

Policy responses.  There are two components here. First, we have updated our fed funds rate forecast to include six more hikes this year (with a 50-basis-point hike likely in May), plus four more next year. This will take the policy rate above the 2.50% neutral level. Second, we are assuming a fiscal policy response in China aimed at negating any downside effects on growth from the Russia-Ukraine conflict, in light of the high weight authorities place on stability and Premier Li Keqiang's recent announcement of a 5.5% approximate GDP growth target this year. This stimulus is likely to largely take the form of public investment spending. In most eurozone countries, fiscal policy is also working to mitigate the impact of higher energy prices on the consumer, while the ECB is gradually reducing monetary accommodation.

Updated GDP Forecasts

Our updated global GDP forecasts take into account the effects above. The intensity and importance of these effects vary by region, but the overall impact outside of Russia and Ukraine is modest. We forecast a 60-basis-point (bps) reduction in global GDP growth to 3.6% this year relative to our previous quarterly update, followed by a 20 bps fall in 2023.

Among the regions we track, the eurozone is forecast to take the biggest hit to growth from the Russia-Ukraine conflict, at 1.1% this year, given its proximity and its higher exposure to global energy costs. The largest driver of lower U.S. growth, in contrast, comes from higher domestic interest rates and not the Russia-Ukraine conflict; U.S. growth falls by 60 bps. Asia-Pacific is relatively insulated outside of the energy import cost channels, and emerging markets are split along the lines of energy dependency.

Russia-Ukraine

The Russia-Ukraine conflict remains geographically contained. We expect the economic impact to peak in second-quarter 2022, but it could drag on amid potential protracted on-again, off-again fighting. Despite its stated alliance with Russia, we assume that China will stay out of the conflict, providing no direct support.

Depending on how the conflict evolves, some sanctions may be removed. But many are likely to remain in place even in the event of a significant de-escalation or end of the conflict. Many Western businesses have already cut ties to Russia or significantly reduced or suspended operations. We are not going back to business as usual, and there will be some permanent de-integration of Russian trade with the West.

We forecast Russia's GDP will fall by 8%-9% this year (we forecast 2.7% growth previously) and stay relatively flat next year. This lower output will affect Russia's (and Ukraine's) near abroad via gravity effects, as well as countries that rely heavily on Russia and Ukraine for food (e.g., Northern Africa).

U.S.

The world's largest economy is relatively unaffected by the Russia-Ukraine conflict, given its energy independence and overall weak trade and financial links to these countries. Households and firms can largely absorb higher energy prices, including by using savings buffers built up from government COVID-19-related transfers.

The Fed tightening cycle is the main factor behind the growth slowdown for now. Given inflation prints were well above their approximate 2% target, exacerbated by the Russian-Ukraine conflict, the Fed has turned more aggressive. We foresee six to seven rate hikes this year, with at least one 50 bps hike likely in May; in addition, we could see four more hikes next year, depending on the data. This trajectory will take the Fed beyond the neutral rate of 2.5% to reach 2.75%-3.00% in 2023. To further tighten monetary conditions, we expect the Fed to start reducing its balance sheet by selling mortgage-backed securities and Treasuries starting around mid-2022.

We now forecast U.S. GDP growth at 3.2% this year, with the economy moving back toward its pre-COVID-19 path. Fiscal consolidation (higher government savings) will be offset by households drawing down their COVID-19 savings. Income distribution worsens in our baseline scenario on high food and fuel inflation, which hits lower-income households relatively hard.

For further details, see "Economic Outlook U.S. Q2 2022: Spring Chills."

Europe

Higher energy prices are the main driver of the European GDP growth slowdown for now. We also see a lower impact from the Russia-Ukraine conflict (via gravity effects) as we move from east to west. Further, supply-chain issues are more relevant in Europe than in the U.S.

The economy has exhibited good momentum in the wake of the omicron variant. Demand--now shifting to services--and confidence are still relatively strong, although the latter has fallen from high levels since the Russian invasion. Excess savings accumulated during the pandemic provide households with temporary buffers to the current price shock. Labor market developments continue to outperform the U.S., and unit labor cost growth remains contained, in part because many wage agreements were signed in late 2021. Fiscal and monetary stimulus has further supported activity, but these effects are fading.

Core inflation, at 2.7%, was much lower than in the U.S. (6.5%) in February, suggesting that the European Central Bank (ECB) has scope to be patient. We forecast the ECB to move in late 2022 and to keep its policy rate below neutral (1.50%) until mid-2024. Balance-sheet normalization will not start before 2024 and will involve passive normalization in the form of letting maturing bonds roll off, rather than outright sales.

We forecast Europe's GDP growth at 3.3% this year, with 1.9 percentage points carried over from 2021. Spain will catch up in 2022, while Germany is still hindered by supply-chain issues. There is less fiscal space than before COVID-19, but discussions over EU fiscal rules will provide some room to maneuver. The eurozone economy will regain its pre-COVID-19 path by 2025. Finally, the EU recovery plan is underway, with 16% of grants and 5% of grants already disbursed.

For further details, see "Economic Outlook Eurozone Q2 2022: Healthy But Facing Another Adverse Shock."

Asia-Pacific

In Asia-Pacific, the most direct link to the Russia-Ukraine conflict is energy dependency. Most countries in the region run an energy trade deficit. Higher energy prices are the main impact variable from the conflict, hitting both growth and inflation. Overall, however, the effect of Russia-Ukraine on Asia-Pacific growth is modest. A more aggressive Fed is also an important forecast driver in the region.

China will keep growth close to 5% with a fiscal stimulus to offset any growth shock from the conflict. This will likely center on infrastructure investment and easier monetary and property policy. The service sector and household sector recoveries are still soft.

For India, the key impact from the conflict is via higher energy prices, which affect inflation and the current account. While financial markets would probably want to see the Reserve Bank of India lean toward tighter policy, whether it will do that remains to be seen, given its focus on growth.

Advanced economy central banks have raised rates, and the Monetary Authority of Singapore has tightened as well. But not the Bank of Japan, which is why the yen weakened significantly following recent Fed news. Emerging Asia-Pacific central banks will face less pressure than their counterparts in EMEA (Europe, Middle East, and Africa) and Latin America.

For further details, see "Asia-Pacific Economic Risks, Thy Name Is Inflation."

Emerging markets

Emerging markets (EMs) will feel the most impact from the Russia-Ukraine conflict. They were also the most affected by the COVID-19 pandemic. But as always, there is much variation within the region. Emerging EMEA, including North African food importers, will be most affected by gravity plus much higher borrowing spreads. Latin America has limited fiscal space to offset any impact and is facing political issues around higher fuel prices. Emerging Asia is the least affected.

Chart 2

Broadening inflationary pressure means we now expect tighter monetary policy across most EMs. Central banks with less anchored inflation expectations will need to raise rates. Rising rates in the U.S. are likely to feed tighter monetary conditions in those EMs that have dollar pegs (e.g., the Gulf states and Saudi Arabia specifically), follow the Fed closely (Mexico), or are at an early stage of their hiking cycles (South Africa). A flight to quality spells higher financing costs and markets being closed to weaker credits, while a strong U.S. dollar will lead to higher debt service and import bills.

External financing needs don't look particularly high from a historical perspective. Many EMs are running current account surpluses, or if they have deficits, these are generally small. EMs such as Indonesia and South Africa, which have traditionally run large deficits, now have surpluses. In a similar vein, short-term external debts are low, at least compared with foreign exchange reserves.

That said, there are pockets of weakness. Turkey (unsurprisingly) stands out on account of its large external debt burden that needs to be rolled over regularly. Otherwise, current account vulnerabilities are larger than most seem to appreciate in Chile and Poland. And higher commodity prices (and import bills) could bring a few other countries, such as India, into this camp.

For further details, see "Economic Outlook Emerging Markets Q2 2022: Growth Slows Amid Higher Commodity Price Inflation."

Downside: Russia-Europe Trade Rupture

Our downside scenario involves a much greater impact from the Russia-Ukraine conflict on the rest of the world than in the baseline. Namely, it features a broad-based rupture in Russian-European trade. Whether this action would be initiated by Russia or the West is indeterminate, in our view. We are not assuming a widening of the conflict that would invoke NATO's Article 5. The trade rupture would go beyond gas and energy flows to include food commodities as well as a suite of industrial minerals that are critical to manufacturing, including palladium and nickel.

The economic impact on Europe of such a trade rupture would be material. Parts of the pan-German industrial complex, including but not limited to the automotive sector, would likely be debilitated. This would include a network of Eastern European countries that have been brought into supply chains in recent decades.

The shock would cause meaningful drops in output, employment, and sentiment. Market reaction would be sharply negative, with a flight to quality, spread blowouts, higher volatility, and sharp market sell-offs. The euro could fall below parity against the U.S. dollar. Liquidity would suffer, and market access would likely be closed for risker segments.

Official intervention to limit the financial damage would be highly likely. Central banks may intervene in government and corporate markets to purchase debt of the most affected firms. They are also likely to open generous liquidity facilities, as in the global financial crisis. Governments would likely once again roll out aggressive stimulus packages, probably transfers, where fiscal space permits.

While the economic damage would be concentrated in Europe, damage would still occur worldwide. Market and confidence declines would lead to sharp drops in household and firm spending, sending most economies into recession. EMs would likely be hard hit once again.

Energy prices would spike in this scenario: Oil could exceed $150 per barrel before moderating. While this would be a windfall for a number of energy exporters, it would result in significant demand destruction for many households and downstream firms across a wide swath of economies.

In such a scenario, Russia is likely to continue to supply energy as well as minerals to China. This means the West would feel the majority of economic damage, although China would suffer an external demand shock that would clearly be large enough to move the macro needle. India would also continue to receive gas shipments from Russia in this scenario, with perhaps less damaging spillovers from the West, given its lower connection to global manufacturing supply chains.

In addition to geopolitical developments, the duration of this shock would depend on the energy supply response from the rest of the world.

No Cause For Complacency

While the global economic impact of Russia's invasion of Ukraine has been modest so far, there is no cause for complacency. The longer the conflict drags on, the higher the risks. Buffers built up by households during the worst of the pandemic are sizable, but they will not last forever. Moreover, the fall in confidence could pick up speed if the conflict and associated economic pain on all sides drag on. The worst of the economic impact from the conflict is therefore likely still to come.