John Kemp

LONDON, (Reuters) – Recession in Europe or North America could be the price of defending freedom and resisting aggression in Ukraine.

U.S. and European leaders now face an unpleasant choice as they decide how aggressively to use economic sanctions in response to Russia’s military invasion of Ukraine.

It is morally imperative to apply maximum economic pressure on Russia quickly to stop the fighting in Ukraine and to repel Russian forces that Moscow claims are engaged in a special operation with no plans to occupation.

However, the economic imperative to safeguard businesses and job opportunities at home is to minimize fallout for households with lower incomes and continue support for sanctions policy.

Top policymakers seemed to believe that they were able to reconcile their objectives by a controlled strategy of sanctions escalation exempting oil- and gas trade in mid February.

This plan was thwarted by Russia’s slow advance on the battlefield, and enormous diplomatic and public pressure from U.S. leaders and European officials to increase sanctions quickly.

U.S.-European policymakers have to choose between applying maximum pressure on Russia via cutting off oil purchases and a modest approach that will prevent recession.

RECEPTION INDICATORS

Before the invasion, there was a rapid recovery of the economy after the pandemic. Prices were increasing rapidly and interest rates were going up.

Flattening U.S. Treasury yield curves indicated that there was a higher probability of either a slowdown in mid-cycle or an end-of-cycle recession within the following year.

Russia’s invasion, and the subsequent sanctions, have dramatically accelerated these trends. Supply chains were disrupted, which sent energy and food prices up and flattened the yield curve.

Demand-side shocks such as the 2008/2009 financial crisis and 2020/2021 pandemic were possible to offset with lower interest rates, purchasing bonds and cutting taxes.

But the invasion and sanctions are a supply-side shocks that have cut the global economy’s production capacity so they cannot be offset in the same way.

Boosting demand by more bond buying, cutting taxes or increasing government spending would simply worsen the production-consumption gap and fuel even faster inflation.

The global crisis could disrupt trade in crucial raw materials and industrial parts. These components include aluminium and nickel as well as car parts, ocean shipping, overland railroad freight, and other noble gases.

But the biggest and most immediate impact is being felt in petroleum and , where Russia is one of the world’s top exporters, and grain, where both Russia and Ukraine are major global suppliers.

Food and energy prices have been on the rise for the last 50 years. At the same time, wages are rising slowly and are putting pressure both on the household and business finances.

Low income households will suffer in both advanced and emerging economies due to the fact that they tend to spend more on fuel and food than their income and are less likely change their spending habits.

UNCONTROLLEDESCALATION

Top U.S. and European policymakers seem to have been alert to the risks when threatening to impose unprecedented sanctions in an effort to deter Russia’s invasion.

U.S.- and European sanctions were carefully designed to prohibit trade in oil, natural gas, or other energy products from the embargo. They also permitted energy-related financial transactions.

The assumption was that the sanctions would increase gradually and that measures targeting oil-and gas flows would only be applied last.

This controlled escalation strategy was created to punish and deter Russia, while also limiting the costs of motorists and households in America and Europe.

Both sides appear to have underestimated the time it would take for the conflict to be resolved.

Russia was wrongly able to win a quick victory in the face of sanctions that threw its economy into chaos.

Both the United States of America and Europe seemed to assume that incendiary sanctions could be used to deter or bring an invasion to a halt, before any economic consequences were felt.

The West now faces a wider range of sanctions, which could be more severe than expected, causing economic disruption.

LIMITING DISRUPTION

The U.S. policymakers and European officials seem to be calculating that they can take strong sanctions action while still allowing oil and gas traders to keep buying Russian fuel.

Most traders, however, have decided that Russian exports are not worth the reputational and legal risks. This has caused oil flow to stop.

Shell (LON 🙂 experienced the effects acutely. Shell (LON:) was so upset by the public reaction that it purchased a Russian crude cargo in March 4 and then apologized for it, saying it would cease spot purchases.

The United States is now under pressure to end Russian oil imports. Europe is less dependent on Russia.

Oil and gas prices have already risen due to the possibility that Europe and the United States might impose an embargo. This could lead to oil and gasoline prices reaching levels that are unaffordable for most households and businesses if they continue for a prolonged period.

Russia responded by indicating that it would cut its oil and gas exports should economic warfare continue to escalate. This move could trigger an immediate, full-blown energy crisis.

It is impossible for the United States or Europe to replace Russian oil exports entirely in 12 months.

European economies are more at risk than others due to Russia’s economic influence.

Are PHASED SANCTIONS AVAILABLE?

The U.S., European and other policymakers might announce plans to reduce their oil and gas imports from Russia in a set time frame over the next two- to three year period.

This gradual reduction of Russian oil and gasoline purchases would look similar to the previous sanctions against Iran’s oil exports.

A similar move could give you more time for replacement supplies, including from Saudi Arabia and Qatar as well as Iran, Venezuela, Venezuela, and other countries over the next 12-36 months.

This could give the U.S., European and other policymakers more leverage in negotiations with Russia, while also reducing or eliminating immediate upward pressures on energy prices.

Even though progressive sanctions are less effective than traditional ones, they can be more beneficial if they help to limit economic collapse in North America and Europe. They also make the countries more financially and politically viable in the medium-term.

Other columns:

– After Russia invades Ukraine, global recession risks increase (Reuters, March 4)

Reuters: Oil prices and oil consumption are under threat from an inflation shock (Reuters, February 10)

– Fed searches for elusive soft landing (Reuters, Feb. 2)

John Kemp is a Reuters Market Analyst. His views are his alone