Tightening Financial Conditions Could Spell Trouble For World Economy

Due to climbing energy prices, falling stocks, and the market turmoil from Russia’s unprovoked invasion of Ukraine in late February, global financial conditions are now at their tightest since early 2016.

Reflecting the availability of funding in an economy, financial conditions are strongly correlated with future growth and are closely watched by central bankers. The spending, saving, and investment plans of businesses and households are dictated by how loose or tight conditions are.

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Goldman Sachs has shown that, in the past, a 100-basis-point tightening in conditions constrains growth by one percentage point in the coming year, and an equivalent loosening gives a corresponding boost.

Despite historically loose monetary conditions in developed markets, the world economy is already threatened by the knock-on effects of more than $120 a barrel oil prices and supply chain setbacks caused by sanctions on Russia and the COVID-19 pandemic. The current tightening will only worsen these effects.

According to Rene Albrecht, a strategist at DZ Bank, if the current situation pushes inflation steadily higher, and "if the central banks take their mandates seriously, you will see a further (tightening) in financial conditions."

"Economic dynamics will slow down further, inflation will be high nonetheless, and you will see second-round effects and then you get a stagflation scenario," Albrecht said.

"Commodity price pressures will likely lead to currency depreciation and heightened inflation, through imported inflation, in some emerging market countries, which will tighten financial conditions and weaken growth," the bond credit rating business, Moody's, reported.

"The magnitude of the effects on individual countries will depend on whether they are net commodity importers or exporters," according to Moody's. The ratings agency expects importers such as China, Turkey, Korea, Japan, India, and Indonesia to take the biggest hit.

Euro zone moves have been sizeable as well. Conditions in the bloc, heavily reliant on Russian energy, are at the tightest since November 2020, and the indicators Goldman uses to calculate its indexes signal no relief.

Central banks, looking to combat the rising inflation that has come on the heels of the global COVID-19 pandemic, will need to raise interest rates sooner rather than later. The unexpected Russian invasion of Ukraine, however, throws a wrench into these plans and leaves central banks with the choice between aggressively fighting inflation in the short term and constraining economic growth, or waiting and suffering stagflation in the long term.