The Reasons Why A War In Ukraine Will Make Inflation Worse

With Russia massing troops at the Ukraine border and the United States discussing potential military involvement, a possible war with Russia over Ukraine seems to be brewing. One would be prudent to consider not only the geopolitical ramifications of a war with Russia but also the inflationary implications, especially when inflation is paramount in the minds of 88% of American voters, according to a recent Rasmussen poll.

As it turns out, a war in Ukraine is likely to be quite inflationary for the United States for several reasons.

• Federal deficits would increase: Wars, in general, are inflationary. Wars involve significant expenditures to employ, transport, arm, and feed troops. Military conflicts also involve purchasing weapons, ammunition, and military equipment. The cost of our involvement in Afghanistan was an estimated $3 trillion. The additional spending of a war in Ukraine will undoubtedly increase the Federal deficit and not in a way that makes the U.S. economy more productive in the short or long run.
• Monetary policy would have to ease: To finance that war spending, the U.S. government will have to issue additional Treasury bonds. The Federal Reserve, in turn, will have to keep interest rates low to minimize the debt service costs for the U.S. Treasury. Given our already near-record Debt/GDP ratio, the Federal Reserve would be even more hamstrung from raising interest rates or reducing its Treasury bond purchases in the case of a conflict in Ukraine. You simply can’t fight a war successfully with a hawkish Fed. As was the case with the Vietnam war or the Iraq war, the Federal Reserve will have to loosen monetary policy, unleashing additional inflationary pressure on the economy.
• Energy prices are likely to rise: Generally, oil and natural gas prices rise sharply when wars happen, as armies consume enormous amounts of oil. In the early 2000s, when we invaded Afghanistan and then Iraq, oil prices increased seven-fold from $25 per barrel in September 2001 to $140 per barrel in September 2008, representing an oil price inflation rate of more than 25% per annum during that period.  In addition, Russian natural gas and oil might stop flowing to Europe, further raising the price of energy in Europe and to a lesser extent around the world. It’s self-evident that rising energy prices will increase inflationary pressures, and it’s especially self-evident when one of the participants happens to be one of the world’s largest exporters of oil and natural gas.
• Shortages would probably worsen: A war would not just increase aggregate demand for energy; it would also increase demand for semiconductors and a wide range of commodities. Rest assured that the U.S. military will go to the front of any line for semiconductors or commodities in short supply. If you have been waiting to buy a car that isn’t being produced right now because of a semiconductor shortage, you might need to prepare to wait a lot longer if the United States gets involved militarily in Ukraine. Alternatively, you might reconsider that used car purchase, despite used car prices that are already at nosebleed levels.
• Food prices could increase: Because natural gas is an important input into the production of fertilizers, it is problematic if natural gas prices increase further due to reduced Russian natural gas exports during a war between the United States and Russia over Ukraine. In 2021, fertilizer prices more than doubled due to rising natural gas prices in Europe. If a war in Ukraine breaks out, fertilizer prices could rise further, causing farmers not to plant on their marginal acreage at a time when grain inventories are already remarkably low. Less acreage under cultivation means less grain production, likely resulting in higher food prices worldwide. It also could lead to more food shortages.
• U.S. dollar could depreciate: If the United States decides to enact draconian financial sanctions against Russia, such as kicking it out of the SWIFT system for global electronic payments, it might cause problems for Russia, but it would also be inflationary for the United States. Without the SWIFT system, Russia would have to sell its exports for currencies other than the U.S. dollar. As a result, countries like China and Germany, which currently purchase Russian energy exports with dollars, would not need to hold as many dollars as foreign reserves. And lower demand for U.S. dollars could result in a depreciation of the United States exchange rate, making imports more expensive for the United States. In a worst-case scenario, Russia’s removal from SWIFT could create a catalyst for other countries to set up an alternate payment system, which would further undermine the dollar’s role as the world’s reserve currency.

With all of that said, it may well be that the United States will experience persistently high inflation in the coming years anyway, war or no war. Nevertheless, it is undoubtedly true that, all other things being equal, a conflict in Ukraine will make inflation worse, and potentially a lot worse, for the reasons described above.

Going to war is always a difficult decision involving many geopolitical, economic, and human rights considerations. Among those considerations, there has not been enough discussion about the inflation implications of a potential war with Russia over Ukraine at a time when inflation is already quite high. 

Disclosure: This article is for informational purposes only and is not a recommendation of a particular strategy. The views are those of Adam Strauss as of the date of publication and are subject to change and to the disclaimer of Pekin Hardy Strauss Wealth Management.