The Three I’s- Invasion, Inflation, and Interest Rates: Dr. Andreas Dombret

On October 17th, the Initiative on Central Banking and Financial Policy hosted Andreas Dombret, who delivered a lecture at SIPA on The Three i’s: Invasion, Inflation, and Interest Rates. Hosted by Professor Patricia Mosser. 

Beginning with the Russian invasion of Ukraine, Dombret stressed that the invasion was not going well for Russia. The Russian Army has endured massive casualties, both in personnel and infrastructure lost, and the economy has suffered from the effect of the sanctions. The sanctions are particularly biting, as Russia has failed to diversify their economy out of fossil fuel exports. With this severe limitation, Russia needed to do a hard pivot to China, which is still a work in progress. This is an early sign of a shift to a deglobalized, multipolar world order that Dr. Dombret believes is emerging, and centering around blocs anchored by the US/EU, China, and then a bloc of “neutrals” including India, Brazil, and South Africa.

Dombret also stressed that this deglobalization and “friendshoring” is going to be inflationary, adding to the inflationary stresses already affecting the economy. Those existing inflationary pressures are causing inflation that is high, rising, and persistent. The EU is more exposed to the war, but they had some inflation before March 2022, so it’s clearly not the only cause. With these multiple drivers, inflation is likely to persist in the Eurozone for two or more years. In the US, the inflation situation is different. The US has avoided the worst of the shocks from the war, but US core inflation is much higher than in the Eurozone. This dynamic suggests US inflation is much more demand-driven. This gives the Fed more agency in the matter and they will likely take advantage of that by continuing to hike rates.

The Fed and the ECB are both currently undertaking similar programs of rate hikes, and both central banks are attempting to frontload rate hikes so they won’t have to continue hiking should a recession materialize. Despite these similarities, Dr. Dombret believes the end results will diverge. Estimating neutral rates in the Eurozone to be in the range of 2-2.5 percent with a US range of 4-4.5 percent, the Fed has a longer way to go before stopping. This will likely have severe foreign exchange implications over the next few years as well.

Concluding, Dr. Dombret said that the invasion is making pre-existing inflation worse and “there is no good news here”. The US and EU are facing six interlinking crises: geopolitical, energy, food, inflation, recession, and climate change. Germany in particular is likely going to have to undergo a large adjustment. For the last 20 years, Germany had a “business model” of using cheap gas from Russia to produce exports destined for China, while taking advantage of cheap defense from the US. While there are some bright spots, in particular the fiscal space they have available to them, there will need to be an adjustment.