Do you know how wars impact interest rates?

Highlights

• Russia’s actions have prompted many nations to change their existing policy setup, including a rise in interest rates.
• The cost of interest payments accumulates even after the war has ended, potentially increasing the debt levels of affected countries.
• Central banks may not immediately change their existing interest rate policies until further data on inflation is obtained.

The Russia-Ukraine altercation has left behind a scarring impact on human consciousness and the economy and financial systems. Russia’s actions have sparked widespread turmoil in an increasingly globalising world, leading many nations to change their existing policy setup. While economies are still recovering from the pandemic, they are facing a new challenge that carries an equally dreary outlook.

At the same time, central banks across the globe are moving ahead in their recovery journey from the aftermath of the pandemic. After relying heavily on monetary easing and fiscal expansion, central banks, including the Reserve Bank of Australia (RBA), have been tightening their policies to dampen inflation. The inflation that primarily resulted from supply-side snags and an overall lack of workers made interest rate hikes a defining feature of most pandemic-ridden economies in 2022.

Meanwhile, interest rates played a key role in the recovery journey of most nations, becoming an all-encompassing tool to bring back stability into financial systems. However, with the Russia-Ukraine war looming in the backdrop, major economies might have to change their interest rate policies to better adjust to financial losses from the turmoil. Since economies are facing a range of market forces, it seems difficult to determine how interest rates will exactly respond to ongoing pressures.

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In this ambiguity, let us discuss the potential impact of wars on interest rates:

Rising interest rates and debt

There is abundant evidence in history that large amounts of debt often accompany wars. As nations resort to borrowed funds to finance a war, the cost of interest payments accumulates, even after the war has ended. Since most nations are not directly a part of the Russia-Ukraine war, they might not face this impact. However, current policy measures taken by Russia might worsen its debt woes in the coming months.

Why Did Russia Invade Ukraine?

Of late, Russia decided to raise its interest rates by as much as 20% after its currency tanked to record lows. Additionally, some of the biggest rating agencies have termed Russia’s debt as having a junk status after the imposition of heavy foreign sanctions.

For other nations, the turn of events is not as direct and certain as they face a range of factors. While inflationary pressures have mandated the need for tighter policy action in other countries, there is also a risk of slower economic spending and reduced investment from rising interest rates.

Essentially, central banks are facing a tug of war between controlling inflation and managing slow economic growth. Speculations are rife that central banks of other countries might increase interest rates by a lower percentage than expected after the war.

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Going with the flow

Despite a range of different market forces, most central banks have decided to continue with their existing monetary policy plans. Since inflation is the pressing issue at hand, central banks, including the US and UK, intend to continue raising their interest rates. However, these interest rate hikes may be subject to some revision, provided inflation may not rise by unpalatable levels over the long run.

The rise in inflation is potentially the biggest threat facing economies in the current climate as the war on Ukraine has directly impacted oil prices. Rising energy prices and overall fear of reduced oil supply from Russia have fuelled nations’ anxieties.

The recent rise in Russian interest rates reflects a direct impact of wars on monetary policy, concerning other nations on how this will transcend to their domestic economies. As reports of war and rising prices hit households, they are more likely to curb their spending and demand less. This could turn out to be a worrisome outcome for economies freshly emerging from the pandemic-induced slowdown. Thus, central banks must tactfully find a way out of high inflation without hurting consumer sentiment.

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