Geopolitical tensions, such as armed conflicts and trade disputes, have increased significantly in recent years. Not only do they affect today’s economy, but they also increase the likelihood of tomorrow’s inflation.
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Escalating geopolitical events are having an impact on inflation. They also add to the uncertainty surrounding inflation. This is more complicated than it seems at first glance. International crises and conflicts affect prices through various channels, affecting both the demand and supply sides. Some factors drive inflation up, while others actually have a dampening effect. Which of the two channels – supply or demand – ultimately carries the most weight is therefore a key question if we want to understand the level of inflation now and in the future.
Geopolitical conflicts that lead to disruptions in energy markets, trade flows and global supply chains often result in higher inflation. When raw materials, energy or products become harder to obtain or are even temporarily unavailable, shortages arise, prices go up and inflation increases.
At the same time, uncertainty and declining confidence cause consumers, banks and businesses to become more cautious. Investments are held back, bank lending to businesses and consumers declines, and international trade – which accounts for a significant proportion of income in a small, open economy such as the Netherlands – comes under pressure. As a result, economic growth slows, demand falls and prices drop, which in turn leads to lower inflation.
To analyse which of these two opposing forces prevails, DNB has conducted research into the economic impact of major geopolitical events. These include shocks such as the 11 September 2001 attacks in the United States, the war in Iraq and the war in Ukraine. Figure 1 shows how inflation (panel a) and industrial output (panel b) developed following these shocks. Inflation rose by 0.3 percentage points over a 20-month period, which could have a significant impact given the long-term inflation target of 2%. Industrial output fell by 0.6 percentage points after three months. This suggests that, in the event of a geopolitical shock, supply disruptions generally have a greater impact than falling demand.
For policymakers, it is not only relevant how geopolitical tensions affect inflation today, but also how risks surrounding expected inflation evolve. These risks can be identified using scenarios. In some scenarios, inflation is very high; in others, it is considerably lower. The scenario involving very high inflation occurs in only 5% of cases; in the remaining 95% of cases, inflation is lower. Conversely, in the ‘very low’ scenario, inflation is so low that only 5% of the possible outcomes are even lower. Figure 2 shows that geopolitical tensions lead to a rise in inflation of 0.6 percentage points after 12 months in the ‘very high’ inflation scenario (panel a). However, even in the ‘very low’ inflation scenario, inflation rises by around 0.3 percentage points after 12 months (panel b).
Generally speaking, geopolitical tensions increase uncertainty surrounding inflation. This uncertainty can be gauged by looking at the difference between inflation in the ‘very high’ and ‘very low’ inflation scenarios. Although inflation rises in both scenarios following a geopolitical shock, it rises approximately twice as sharply in the ‘very high’ scenario. As a result, the range of possible inflation outcomes widens further and uncertainty surrounding future inflation increases. That uncertainty appears to be a key predictor of future inflation. The greater the uncertainty today, the greater the likelihood of higher inflation in the coming months and years.
This is important information for central banks, as they sometimes opt for what is known as a ‘looking-through’ approach. This means that they do not immediately counter temporary price rises resulting from a supply disruption by raising interest rates. They assume that the effect will fade once supply has been restored.
In the event of sustained geopolitical tensions and rising inflation, adopting a wait-and-see approach is not a smart choice. If businesses, consumers and employees expect prices to keep rising, those expectations can become a self-fulfilling prophecy with employees demanding higher wages. Businesses will then raise their prices to absorb higher wage costs. As a result, inflation rises further. The effects of geopolitical tensions can therefore continue to be felt in inflation for a relatively long time.
At the same time, it is difficult to formulate a single correct standard response. The consequences of a trade dispute, for example, differ from those of a large-scale armed conflict. The duration of a dispute or conflict is also a relevant factor, and it is precisely this aspect that is often the subject of considerable uncertainty. That is why it is useful for central banks to run simulations of different economic scenarios and not just focus on the baseline scenario. For example, the European Central Bank, in its most recent projections has used ‘adverse’ and ‘severe’ scenarios, in which the conflict in Iran lasts longer than assumed in the baseline and energy prices remain high for longer, and a ‘milder’ scenario, in which the conflict ends more quickly. In this way, policymakers can make a more accurate assessment of the risks of higher or lower inflation, even if those risks are not yet reflected in regular inflation expectations.
Geopolitical tensions increase the likelihood of higher inflation in the euro area. They also create greater uncertainty about future price trends. By looking not only at expected inflation but also at the risks surrounding it, central banks and policymakers gain a clearer picture of the challenges that lie ahead.
This background article is part of the series Inflation in Focus, in which we examine various aspects of inflation and its development.
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