 As our President Christine Lagarde said in the March press conference, the Russian invasion of Ukraine is a watershed moment for Europe. The war is first and foremost a tragedy for people, for those who have lost their lives in the violence and for the millions fleeing it. Beyond the suffering and the devastating humanitarian consequences, the conflict also has an economic impact. And we're feeling that here in the Euro area too. In this episode, we're going to look at what the war means for our economy. You're listening to the ECB podcast, bringing you insights into the world of economics and central banking. My name is Katie Ranger. I'm joined by Joel Souza, who is a senior manager in our economics department. Well, welcome to the podcast. Nice to see you here today. Thank you. It's nice to be here. Now, before we start, I think it's worth mentioning that things are very fluid at the moment. We're sitting here recording on the 22nd of March, and there's really a high chance that a lot will have changed even by the time we go out with this episode. I suppose uncertainty really is the best way to describe the situation. That's why in today's conversation, we'll focus on the effect the war is already having on different aspects of our economy, things like prices and growth. Jean, let's start off by talking about where we're coming from, so how the Euro area economy was faring before the war started. Before the war started, the Euro area was in a relatively favorable position, so we were recovering from the pandemic, which we weather better than what is expected initially, also thanks to a very significant policy support. And we were starting, as the containment measures were starting to be lifted, to see some growth recovery appearing. And we were seeing underlying conditions for the Euro area economy gradually improving. In spite of, of course, some headwinds that we were expecting in the last quarter, last year and the beginning of this year linked to the Omicron wave, which we have seen that were not so severe as we were expecting, also thanks to the vaccination campaigns. And therefore, the Euro area economy was on a good path to a strong recovery in 2022. And in particular, from the second quarter of this year, as also further, the containment measures will be relaxed further. There are a few issues, headwinds as you call them, but in general, we were on a good path. Yes, we were on a good path. We returned to the pre-crisis level already at the end of last year. And in addition to that, and very importantly, we had a strong labor market. And an employment rate has been continued to go down. And it's quite low for historical standards. And employment growth has also continued to be positive. And overall, the external environment up to the war was also favorable. And even a little bit more favorable than we were expecting by the end of the year. So all this gave us some confidence that this year, we would have a good recovery from the pandemic. OK, let's turn to look at where things are today and how Russia's war in Ukraine is linked to our economy here in the Euro area. You are in charge of what we call the macroeconomic projections. Now, they're basically forecasts that aim to predict and understand the future state of our economy. And they look at things like economic growth, inflation, wages, trade, things like that. We publish them four times a year. Twice they're carried out by ECB colleagues. And the other two times we work together with economists across the national central banks in the Euro zone. So all of the countries that have the Euro. And our close watchers know them as staff projections. Now, as part of your latest projections, which came out just a couple of weeks ago, you looked at how the war is affecting the economy. And in that, you identified three ways or channels, if you will, through which it can have an impact or it is having an impact. Number one, trade. Number two, commodities. So that's things like raw materials like oil, gas, food. And number three, something that we call confidence. So, let's start with trade. Before I start with trade, I'd like to mention that, of course, this was a very challenging exercise. And as also we mentioned, this was the first, the forecast contained a first assessment of the crisis. And they were basically closed on the 2nd of March with technical assumptions of 28th of February. So why prices of 28th of February and gas prices around that time? So that's a very short time period after the war starting. A short time period after the war started, with, of course, still very imperfect information. Now, let me start then to answer your question on the trade. Of course, trade with us is going to be affected first by the bans on imports and exports and also the exclusion of Russian banks from SWIFT should also make the financing of trade for Russian firms more difficult, which should have an impact on the Russian exports to the Euro area. But I'd like to mention that the direct trade with Russia is a relatively small share of the Euro area foreign demand. It's only 3%. However, even though the size is small, there are other channels that can be more important and I'd like to mention some of these. So first of all, Central and Eastern European countries are half-closetized with Russia and they will be more affected directly by Russia, which would also affect us because the important trade partners of the Euro area. So second, supply constraints, supply change could be affected by the war because first of all, the war can disrupt logistics and transportation also because of the flight and shipping banks, bans in the factory region and supply chain disruptions. And in addition, both Russian and important producers of critical raw materials. And this implies that this could create some problems in global value chains that would worsen the supply bottlenecks that we were expecting that would be improving this year. So for instance, Russia is an important exporter of palladium used in catalytic converters. Ukraine is an important exporter of neon gas, used in semiconductors. And so the war is likely to exacerbate some of the supply bottlenecks and cause further disturbances in terms of the supply constraints with some consequences for inflation. Now, what we have seen so far is that indeed we already seen some signs that trade is weaker since the onset of the conflict and of course, this will affect Euro area exports. And this will be the first channel. Of course, also the Russian economy is expected to go into recession this year and that by itself will also further reduce the external trade of the Euro area. So even though the direct trade between the Euro area and Russia is not that large, there are all these kind of knock-on effects that will lead to it having an impact on the Euro area economy. Exactly. And of course, one of the difficulties is to try to identify where these bottlenecks may occur and maybe sometimes it can be a small share of the market or a critical raw material, but they could create a much greater disturbance. That brings us on to the second channel. In fact, commodities. So as I said before, it's kind of raw materials such as oil, gas and food. And that's a topic that we've actually heard a lot about in the recent weeks. Can you talk us through this channel a little bit? Besides the foods that I just mentioned, these critical raw materials, of course, one of the main issues relates to the fact that Russia is a Euro area main energy provider, accounting for 20% of the oil and 35% of its gas in 2020. And the importance of these commodities for the Euro area, we can expect significant perturbations in these markets, even if there's no ban on Russian oil in the area. So consumers will be reluctant to buy it. Also, some firms are not buying any more Russian oil or gas. And there's also less willingness to finance and ensure transactions with Russian commodities. So of course, it's clear that this is going to cause a perturbation in the energy market, which is implying already a significant increase in the prices of oil and gas, which actually was already going on before the war, but of course now has really surged since the start of the war. And that's something that I think it's fair to say, we're all feeling this rise in energy prices. And it brings me on to the last channel, which is confidence. I think it's fair to say that we're all shaken by what we hear and what we see and what we read about the war every day. And there is a lot of fear and uncertainty about what will happen next. When economists talk about confidence and the effect on economic activity, what exactly is meant here? So how are we seeing the war impacting the economy through this confidence channel? Indeed, the war, given it is so close to the Euro area, and given all the possible ramifications of the conflict, has a clear impact on the confidence of households. And given also this very important impact on energy prices, it further worsens that impact. So in terms of how the economies look at this, so one way that we take into account is that these, for instance, these large energy shocks lead to a precautionary behavior of households because energy is, of course, an essential good and makes people become more cautious and save more. In particular, those that can, but of course those that have less savings, will be forced to restrict the consumption expenditure. And of course, the war will add with that to this. And also the war has created a large perturbation in financial markets, a lot of uncertainty. And this has created on one hand, when there's a lot of uncertainty, the financial market participants increase what we call the risk premium. So they will demand higher rates for lending money. And this will cause, will worsen the financial conditions of firms. Because it's harder for them to get money to invest. It's harder for them to get money to invest because the situation is more uncertain. So who is lending the money? Well, of course, demand a higher rate to compensate for the higher risk. On top of that, of course, also all this uncertainty on what will happen in terms of the war makes firms naturally more cautious in their behavior and this deep prices investment. Let's zoom in a bit to talk about something that we've already touched upon, prices. And indeed, that's our main task here at the UCB, achieving stable prices. Now, already before the war, inflation was higher than in previous years. And energy has been a big topic here. Now, it is worth mentioning that energy prices are what we call volatile. So they are always changing a lot. So how are the recent energy price increases different to what we usually see? And how much of that is down to the war in Ukraine? Energy prices, as I mentioned also before, started increasing more forcefully around mid-2021. So not all of the increase is to the war. Even though, of course, we have seen that already from the end of last year, say, from September onwards, we've seen a very sharp rise in the prices of gas that is relevant for the Euro area. And this affects many geopolitical tensions with Russia. Part of it is linked to the reopening of the economy last year after COVID, which of course led to a strong increase in demand and supply was catching up. And this has exacerbated the recovery in oil prices, which we would be expecting some recovery because the economy before was very depressed because of COVID. But of course, these geopolitical tensions added a much stronger momentum. And the specific circumstances of gas in the Euro area were very important. And this was something that gas, traditionally gas prices tended to follow oil prices. But in this case, there was a very strong decoupling that was a bit of a surprise in the end of last year. And of course, explains why inflation was much higher than expected at the end of last year and beginning of this year. Now, the war has of course amplified all this and energy prices, oil reach almost $140, which is a very very high price and gas prices is also surged. And this of course creates a very important shock to the Euro area economy, driving inflation up. So as you've said, energy is obviously making up a big part of this rise in inflation. But is there anything else driving it? I know you mentioned food prices earlier, for example. We have seen that food prices are also pushing up inflation and they have also increased substantially and they are growing at around 4%. So the HICP component is going around 4% in February, where the average is around 2%. And we see here also on food also the indirect effect of energy and also via transport costs and also the energy that is needed to produce the food. And also via fertilizer prices, which of course also depend very much on energy. It all has a knock-on effect, doesn't it? It's not just that the food isn't there, it's all the things that go into growing that food as well. Exactly. And of course with the war in Ukraine, this effect is going to become worse. And on top of that, of course we have the situation relating with which of course the prices in international markets have grown, have surged since the invasion. But I'd like to mention that the energy component is important not just for the headline inflation, but also is important and sometimes this is a bit overlooked, is also important for the core component. The core is the inflation where we take out the energy and food prices so that those volatile prices. Because energy is such an important input into the production of most goods and services, when you have increases in energy prices like you had last year and the beginning of this year, this will start to feed through to the other components. I mean, of course on processed food, it's very easy to think about that. If you bake a bread, you need to use heat and that will imply that the cost will go up. It's energy, yeah. It's energy. So but of course of cars, if you think transportation, tourism, all that is affected by increased energy. And so when you have these very large shocks, you get to a point where the firms cannot fully accommodate all the shock and pass through some of this increase into the consumers. And we have in terms of our estimations, we think that a large part or significant part of the increase in co-inflation is also due to energy and is also contributing to increase this component which now in CERI was 2.7 percent. Still, of course, much lower than headline which was around 5.9. But it's reflecting also these indirect effects, what we call indirect effects from energy. Well, that brings me on to the next part of our discussion, of our conversation. And I want to think about what this all means and how we see the euro area economy fairing in the future as a result of those effects that you've just mentioned. Now, we've already said that there is a lot of uncertainty as to what will happen. The EU has already announced its fourth sanctions package in the space of one month. Discussions and negotiations are still continuing. And of course, we all hope that the horror will be over soon. On the ECB side, President Lagarde has repeatedly confirmed that we're carefully monitoring developments and will take whatever action is needed to secure price stability and safeguard financial stability. So this was a very challenging environment to have to forecast what's going to happen with the euro area economy. And in the last set of projections, you came up with two additional scenarios to the usual projections. Could you talk a bit about those two additional scenarios? Indeed, the outlook is very uncertain and depends crucially on how the war unfolds, the impact of the current sections and what other measures may come also from the governments. Of course, for an economist, we have to be humble in this situation because when we are living in a very high uncertainty environment, we also have to be humbled in terms of the abilities that we have in forecasting the future of the economy. So our usual projections are quite detailed and are quite a heavy exercise. And of course, when reality is changing so quickly, as we saw now in the war and also as we saw during COVID, we have to resort to scenarios that let us try to map the level of uncertainty that we see. And this was the case in this exercise where we have considered one adverse scenario and one severe scenario. Basically, the adverse scenario implies stricter sanctions to Russia than we had foreseen in the baseline, leading to disruptions in global value chains. We also assumed that there would be some gas supply shortages that would create a higher energy cost and cut scenario production and assumed also some increase in risk premium financial markets. This would imply a significantly lower growth this year by 1.2 percentage points and higher inflation by 0.8 percentage points also this year compared to the baseline. So we would see the typical supply shock reaction of lower growth and higher inflation. Still, we would still see positive growth this year. For the years ahead in this adverse scenario for 23 and 24, we don't have major revisions to the baseline. And this is because of the assumption that we make that the conflict would be resolved over time and most of the detrimental effects of the war would be felt in 2022, which is an important assumption that we also assume for the severe scenario. And then they would fade out in 23 and 24. And it would fade out in 23 and 24, even though the sanctions would remain until the end of the projection horizon. Now, in a severe scenario, we would assume harsher cuts in energy supply, higher commodity prices, and higher reaction of the economy to that. And also we assumed what we call second round effects. So inflation would be persistently higher. So basically it means that wages would grow more strongly because of the high inflation numbers. And this would result in high inflation and more persistent inflation process. That's when people negotiate higher wages because of the inflation and it kind of entrenched itself. And that of course increases the cost of firms and then they would have to pass through those costs into higher prices. And we have some wage price reinforcing mechanism that would lead to high inflation in the future. So in this scenario, inflation will be 7.1% in 2022 and 2.7% in 2023. But in the severe scenario, in 2024, we would go back to the baseline level of 1.9%. And this is also true for the adverse scenario. So over the median term, inflation always goes back to levels closer to our target or somewhat below in the adverse scenario. So when the economy is hit over time in the medium term, this contextually effect leads to lower demand which would imply that inflation would gradually normalize. Of course, in these scenarios, we have also the assumption that energy prices also over time start normalizing after the serious shock this year. But to some extent, I think it's important to note that when you think about the impact of commodity prices on inflation, these prices, this impact is, at the moment, is a level effect. So there's a big increase in energy, but we will need that energy would keep increasing at very high rates to produce more sustained inflation. But of course, this scenario assumed that the energy markets would gradually normalize and also assumes that if there are any energy supply shortages over time, this would be replaced by other sources and production will recover. But it's important to retain that the shock is contextually. It's not, it's a supply shock. It affects confidence. It affects, it has detrimental impact on the economy. And we assume that also creates some unemployment in the short term. But over the medium term, also considering that the EROA has those elements of resilience that I mentioned, so favorable labor markets, we were recovering from the pandemic and the accumulated savings, we expect the EROA, even in these more severe scenarios to weather these shocks with positive growth rates. Chouin, before we wrap up, we ask all our guests on the podcast for something they would recommend to our listeners. Who'd like to learn more about the topics that we've been discussing today. Of course, we are living in a very uncertain world and I can recall a speech by Ben Bernanke in October 2007, where he talks about the implications of uncertainty for monetary policy. And of course, he concludes that when faced with high uncertainty, like we have now, we have to be humbled with our forecast and also with our ability to forecast the future course of the economy. This implies that we need to continue to work on scenarios. We need to continue to develop this and monitor the situation and update them to try to map all the possible outcomes that we can have from this very, from this dreadful war and provide the best advice to the governing council on how best to react. But indeed, in the earlier years, since the, say, 2007, we have been through a lot of crisis. So we have been, after the global financial crisis, we have the Solvendat crisis. We have the COVID pandemic and now we have the war. And I think we have been developing over time, not just DCB, but also at EU level, a lot of instruments that allows us to deal with shocks of ever greater magnitude. And I'm sure that this will also happen now. And because we have learned a lot how to deal with crisis, we are better able to see the overall vulnerabilities also in a still building monetary union. And I'm sure that this will also be the case now. Well, I think the best we can hope for is that the war is soon resolved in a peaceful way, putting an end to the violence and trauma for all those suffering from it. Jeral, thank you very much for being here with us today and for breaking down this very important topic for us. Thank you. Well, that brings us to the end of this episode. Check out the show notes for further reading on this topic. You've been listening to the ECB podcast with Katie Ranger. If you like what you've heard, please subscribe and leave us a review. Until next time, thanks for listening.