1. General assessment of the macroeconomic situation

Activity indicators have moderated and confidence has been hit

Most economies experienced strong economic growth in 2021, as rising vaccination coverage and improved treatments mitigated the severity of the pandemic, and policy support and favourable financial conditions helped demand to rebound. Labour market slack was steadily reduced in all the major OECD economies, in some cases taking employment rates above pre-pandemic peaks. The economic disruptions from the wave of infections brought by the Omicron variant in late 2021 and the early months of 2022 generally proved mild in most countries, but global GDP growth more than halved in the first quarter of 2022, with output declining in several advanced economies.

High-frequency data are now showing some of the adverse effects of the war on activity and prices. Global mobility has continued to improve, but global industrial production, retail sales and car sales all declined in March and April (Figure 1.7, Panels A and B). Survey evidence also suggests that the war and the health-related restrictions in China are having a sizeable impact on business activity and confidence (Figure 1.7, Panels C and D). Indicators of business confidence and output have fallen sharply in China, reflecting the lockdowns in many cities and ports, and declines have also occurred in Russia and a number of major European economies, including Germany. Consumer confidence indicators had already begun to weaken ahead of the war, especially in the United States, but tumbled further in March, particularly in Europe, and declined further in April and May. In Russia, air traffic has slowed considerably, with around one-third fewer commercial flights from major airports since the war began, and prices have risen sharply. By late April, consumer prices were around 11% higher than at the start of February. Taken together, these indicators suggest that global GDP growth could be very weak in the second quarter of 2022.

Figure 1.7. Many activity indicators have recently weakened

Note: Data in Panel A are PPP-weighted aggregates. The retail sales measure uses monthly household consumption for the United States and the monthly synthetic consumption indicator for Japan.

Source: Google LLC, Google COVID-19 Community Mobility Reports, https://www.google.com/covid19/mobility; Markit; OECD Main Economic Indicators database; Refinitiv; and OECD calculations.

 StatLink https://stat.link/85c031

The downturn in consumer confidence is likely to be related to the squeeze on real household incomes coming from the acceleration in inflation as well as higher uncertainty. In most OECD economies, real household disposable income was already declining on a year-on-year basis in the last quarter of 2021, despite strong employment growth, and in many that decline is estimated to have continued in the first quarter of 2022. This partly reflects the phasing out of transfers associated with the pandemic, especially in countries like the United States and Canada where such payments were large, as well as the erosion of real wages. Economy-wide real hourly wage growth is now negative in most OECD economies (Figure 1.8).3 The additional increases in energy prices seen since the start of the war in Ukraine are pushing headline year-on-year inflation well ahead of the inflation rates expected at the time of collective bargaining to set wage rates in 2022.

The impact of rising inflation on real incomes has not been uniform across households (Brainard, 2022).4 The increase in expenditure resulting from recent food and energy price changes represents a larger proportion of total spending for lower-income households (Figure 1.9), and those households have limited scope to offset this by drawing on savings or reducing discretionary expenditures.5 This is one reason why governments in many OECD countries have taken action to cushion recent rises in energy prices (see below).

The difference between the degree of inflation experienced by many households and the official measure may be one explanation for the persistent difference between household survey measures of inflation and actual inflation in the euro area (Figure 1.10), with perceived and expected inflation highest amongst the lowest income quartile. Over and above the actual budget shares of different items, perceived inflation is also influenced by those prices which are most salient for consumers, such as electricity bills in Europe, gasoline in the United States, or common food items (Georganas et al., 2014; D’Acunto et al., 2021). These items are encountered regularly, relatively homogeneous (facilitating price comparisons over time) and make up a significant share of household expenditure. With such prices being among those registering the largest increases over the past eighteen months, perceptions of inflation have risen sharply since 2020 and run ahead of the measured rate for many people. This increase could place upward pressure on wage bargains over the coming year.

The COVID-19 pandemic has complicated the interpretation of labour market conditions, but it has become increasingly clear that labour markets in most OECD economies are now relatively tight. The OECD-wide unemployment rate is back to the lowest level in the past two decades and nominal wage growth has picked up in the United States and a few other countries to levels that are high by pre-pandemic standards. Most OECD economies are now experiencing labour shortages (Causa et al., 2022), with sharp increases in vacancies even in countries that favoured job retention schemes (Figure 1.11). Large declines in international migration since the onset of the pandemic have also contributed to labour shortages in some countries.

Figure 1.8. Higher inflation is hitting real wage growth

Real compensation per hour worked.

Source: OECD Economic Outlook 111 database; and OECD calculations.

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Figure 1.9. The surge in food and energy prices has disproportionately affected lower-income households

Percentage increase in household expenditures for the lowest and highest income quintiles

Note: Estimated impact of the year-on-year increases in energy and food prices in April 2022, using consumer basket weights in 2019 for the United States and Japan, and 2015 for other countries. Data are ranked according to the first quintile (20% of households with the lowest income). Energy corresponds to natural gas, electricity and other fuels, and includes motor fuels as well for the United States. Food corresponds to food products and non-alcoholic beverages.

Source: Bureau of Economic Analysis; Statistics Bureau of Japan; Eurostat; and OECD calculations.

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Figure 1.10. Perceptions and expectations of euro area consumer price inflation by income quartile

Note: Actual inflation corresponds to headline harmonised consumer price inflation.

Source: OECD Economic Outlook 111 database; European Commission; and OECD calculations.

 StatLink https://stat.link/qh5xbp

Figure 1.11. Most OECD countries are experiencing labour shortages

Job vacancy rates, 2022Q1 or latest

Note: Job vacancy rates (i.e. vacancies as a share of employment) are on a quarterly basis and seasonally adjusted, with the exception of Canada.

Source: Australian Bureau of Statistics (AUS); Statistics Canada (CAN); DARES (FRA); Office for National Statistics (GBR); Central Bureau of Statistics (ISR); US Bureau of Labor Statistics (USA); and Eurostat (OECD-EU).

 StatLink https://stat.link/7nczga

Financial market conditions have tightened significantly

Faster and more extensive policy interest rate rises in advanced and emerging-market economies and the war in Ukraine have led to a substantial tightening of global financial conditions. In particular, volatility has increased significantly in equity, bond and foreign exchange markets (Figure 1.12), equity prices have declined, government bond yields have risen and most currencies have depreciated against the US dollar.

• Weaker growth prospects and higher bond yields have weighed on equity markets in most advanced countries, including the United States. Strong exposure to the conflict region has added to downward repricing in the euro area and most Eastern European economies (Figure 1.13, Panel A). Equity prices have risen in a few commodity-exporting economies, as well as in Türkiye, but recent COVID-19 outbreaks and continuing vulnerabilities of highly leveraged real estate companies have hit equity markets in China.

• Government bond yields have increased in most countries since January (Figure 1.13, Panel B). In the United States, the yields on 10-year nominal and inflation-adjusted government bonds have risen by around 1 percentage point over this period. The rise in 10-year nominal yields has been somewhat higher in the euro area, and sovereign bond spreads have widened within the area. Nominal yields have also risen in the major emerging-market economies.6 In contrast, yields have hardly increased in Japan, reflecting lower inflationary pressures, yield curve control and no immediate sign of policy tightening.

Figure 1.12. Financial market volatility has risen

Note: Implied volatility as measured by the VIX index can be interpreted as the market expectation of risk (future volatility) and is derived from at-the-money call option prices (interpolated) using the Black-Scholes formula. For more recent data, the Cox-Rubinstein binomial method is used for American-style options. The MOVE index is a yield curve weighted index of the normalised implied volatility on 1-month Treasury options which are weighted on the 2, 5, 10 and 30 year contracts.

Source: Refinitiv; and OECD calculations.

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• Corporate bond spreads (relative to government benchmark bonds) have increased since early 2022 but remain moderate by historical standards in the major advanced economies, reflecting generally healthy corporate balance sheets. However, bank credit default swap spreads have risen markedly, likely reflecting concerns about weakening growth prospects.

• The US dollar has appreciated since the onset of the war in Ukraine, partly reflecting the faster anticipated pace of policy interest rate increases in the United States relative to most other advanced economies, especially Japan (Figure 1.13, Panel C). With a few exceptions due to idiosyncratic factors, such as Argentina, the currencies of most major commodity-producing emerging-market economies have either appreciated or depreciated only slightly against the US dollar since January.

Figure 1.13. Financial market conditions have tightened

Note: “Latest” refers to the change between the average of January 2022 and the latest available data up to June 1. “Maximum” and “Minimum” refer to the largest increases or falls relative to the average of January 2022. Based on a 10-day average of daily observations.

Source: Refinitiv; and OECD calculations.

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Trade momentum is easing and supply chain pressures remain acute

Global merchandise trade, container port traffic and air freight traffic indicators were all expanding in early 2022 (Figure 1.14, Panel A), prior to the war. International travel was also gradually recovering, other than in the Asia Pacific region where widespread border closures and restrictions remained. War-related disruptions curbed this trend in March, with a particularly sharp downturn for air freight. Global new export orders have also weakened, with declines in China, the euro area and Japan (Figure 1.14, Panel B).

Bottlenecks in international freight remain high, and are being accentuated by the Ukraine war and the shutdowns in China. Supplier delivery times rose in many countries in March and April but eased slightly in May. Indicators of freight waiting times and shortages of intermediate goods have also increased (Figures 1.15 and 1.16). The easing of pandemic lockdowns and sanitary restrictions, combined with the normalisation of demand in many regions, is helping to reduce demand-supply mismatch in maritime transport, with shipping costs down from their peaks in late-2021. However, the war has resulted in the diversion of freight from routes that have become non-viable towards others which are already over-stretched and very expensive. With parts of the Black Sea and Sea of Azov unpassable, maritime companies have closed lanes and suspended shipping services. Rail and airspace over Ukraine and Russia have also been shut off, limiting capacity. Commercial air travel and freight traffic by air and sea are being rerouted to avoid Russian air space and ports, becoming more expensive (due to higher insurance rates and longer routes) or ceasing altogether. Container loads in major Russian ports have also declined by 50% compared to a year ago and have stopped in the Ukrainian port of Odessa since early March. The war also risks exacerbating crew shortages, as nearly 15% of international freight crews in 2021 were Russian or Ukrainian.

Figure 1.14. Trade in goods is decelerating and new export orders have declined

Source: CPB Netherlands Bureau for Economic Policy Analysis; Institute of Shipping Economics and Logistics; IATA; Markit; and OECD calculations.

 StatLink https://stat.link/hkd5j3

Figure 1.15. Renewed supply chain disruptions and delays are starting to appear

Note: Calculations are made using real-time vessel position data and take into account the technically possible maximum capacity of each container ship.

Source: Kiel Institute; and OECD calculations.

 StatLink https://stat.link/ozr6uj

Additional disruptions have arisen as a result of the impact of the strict zero-COVID strategy in China. Though air and ocean ports are being kept operational (with workers often remaining on site), lockdowns in Shanghai and other big cities have created labour shortages that affect truck companies, reduce ground handling capacities, and ultimately slow operations in ports. Air traffic has also declined sharply.

Figure 1.16. Shortages of intermediate products have risen in Germany after the onset of the war in Ukraine

Proportion of firms reporting intermediate product shortages

Source: IFO; and OECD calculations.

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Inflation pressures have broadened further

Inflation has been increasing worldwide for more than a year (Figure 1.17, Panel A), with the headline measure of inflation currently above central bank objectives in most economies, particularly outside Asia. Apart from special cases of very high inflation, such as Türkiye and Argentina, headline inflation has increased particularly rapidly in Central and Eastern Europe, Latin America, the United States and the United Kingdom.

Large increases in food and energy prices since mid-2020 have pushed up headline inflation in all economies, even though the increases have not been uniform.7 More recently, the increase in inflation has gone well beyond energy and food in most countries. Core inflation (excluding food and energy) has increased in almost all advanced economies (Figure 1.17, Panel B), even where the recovery from the pandemic is not complete. As with headline inflation, core inflation has increased particularly sharply in Central and Eastern Europe. The distribution of price changes has also shifted considerably. In the United States, the euro area and the United Kingdom, the prices of at least half the items in the inflation basket rose at annual rates above 4% over the year to April (Figure 1.18).

Figure 1.17. Headline and core inflation have risen sharply over the past year

Note: Headline and core inflation based on the personal consumption expenditures deflator in the United States, harmonised consumer prices in the euro area economies and the United Kingdom, and national consumer prices in other countries. In Panel B, the quarterly numbers are quarter-on-quarter percentage changes at an annualised rate.

Source: OECD Economic Outlook 111 database; and OECD calculations.

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Figure 1.18. Large price increases are more widespread in the United States than the euro area

Inflation ranges

Note: The figure shows the distribution of the annual percentage change in the prices of the different goods and services in headline consumer price inflation. Headline inflation based on the personal consumption expenditures deflator in the United States, harmonised consumer prices in the euro area and the United Kingdom, and national consumer prices in Japan.

Source: Bureau of Economic Analysis; Statistics Bureau of Japan; Eurostat; Office for National Statistics; and OECD calculations.

 StatLink https://stat.link/tioe3h

Differences in the severity of the pandemic, the structure of economic activity, the extent of labour shortages and policy responses to the pandemic all help to account for cross-country differences in inflation. Particularly strong fiscal measures in response to the pandemic in the United States helped produce a strong cyclical recovery by pushing household incomes well above their pre-pandemic level. With expenditure on some services constrained by the pandemic and the associated restrictions, more of the rebound in consumption was directed to goods, where supply-chain constraints have been strongest, and was reflected in rapidly rising goods prices (OECD, 2021a; Boone, 2022; Jordà et al., 2022). In contrast, policies in many European economies focused on job preservation, with disposable incomes largely kept at their pre-pandemic level. This led to a slower recovery in consumption with smaller differences between goods and services spending. In Japan, large reductions in mobile phone price plans have helped to keep inflation low.

The patterns of price increases over the past two years suggest that pandemic-related effects account for a sizeable share of the recent increase in headline inflation (Figure 1.19). Prices declined in some of the service sectors most impacted by public health containment measures in the first phase of the pandemic, followed by large price increases as economies reopened. Similarly, the deep recessions in the spring of 2020 triggered sharp falls in the prices of oil and gas, which led many producers to shut down production and curb exploration. The rapid rebound in economic activity thus quickly met supply constraints in energy, contributing to the sharp increases in energy prices since that time.8 A variety of supply constraints associated with the pandemic also meant that goods production could not keep pace with the rebound in demand for goods. As a result, inflation for goods excluding food and energy was generally weak in the first half of 2020 but unusually strong over the past 18 months. In contrast to energy, goods and COVID-affected services, categories of services like financial services or communications, less obviously directly affected by the pandemic, have experienced relatively stable rates of inflation, but with some upward drift, especially in North America (Figure 1.19).

Figure 1.19. The profile and composition of inflation has reflected the effects of the pandemic

Note: Data are for the personal consumption expenditures deflator for the United States; the consumer price index for Canada and Japan; and the harmonised consumer price index for the euro area, Germany and the United Kingdom. The attribution of different service activities to “COVID-affected” or “non-COVID-affected” depends on the categorisation of services within each jurisdiction’s index, but follows a number of general principles, including the notion that services involving travel by the service receiver and/or requiring that the provider and the receiver of the service both be physically present would be classified as “COVID-affected”. Thus, for example, passenger transport, package holidays, hotel accommodation, restaurants, cinemas, concerts, personal care services and dental services would all be included in “COVID-affected services”, while financial services, communications and most education and health services would be categorised as “non-COVID-affected services”.

Source: Bureau of Economic Analysis; Statistics Bureau of Japan; Eurostat; Office for National Statistics; Statistics Canada; and OECD calculations.

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The adverse effects from the war could be much larger

A key potential risk to the projections is that all energy exports from Russia to Europe could cease completely. The impact of such a shock is difficult to quantify, but could be severe if it were to occur through a sudden stop in imports from Russia at a time when stock levels had yet to be rebuilt and there were limited possibilities to switch quickly to alternative sources of supply. The forthcoming EU embargos on imports of coal and seaborne oil from Russia also raise challenges, and could be more disruptive than projected if there are prolonged supply shortages.

Oil and gas represent sizeable shares of EU total energy use.9 A Europe-wide embargo, or a sudden stop to exports by Russia, thus brings a sizeable risk of energy supply disruption as well as rising prices.10 There are large differences across member states, both in terms of the energy mix and the share of energy inputs that originate in Russia. An end to imports of Russian energy is likely to affect sectors in different ways according to their dependency on energy imports from Russia and scope to obtain alternative energy supplies or reduce demand. As energy is a critical input across several industries, the short-run impact on output could be amplified by cascading effects propagating along international and domestic input-output linkages. At the same time, sharp rises in energy prices might also have hefty repercussions on household incomes and demand.

Illustrative assessments of the direct effects on output in manufacturing and market services sectors that might result from an embargo of all of energy products from Russia can be made by combining input-output tables with information on energy use in 2019 from the International Energy Agency (IEA).11 The IEA data provide economy-wide dependency ratios on Russian imports for each of the three different fossil fuels (coal, gas and petroleum products). These can be used to calculate the dependence on Russian energy imports in each sector by using the consumption shares of each respective fuel product in different sectors and assuming that the share of each fuel product imported from Russia is the same across all sectors. The impact on gross output from an energy embargo on Russia is then derived by applying input-output multipliers of energy-related industries.12 After taking into account all direct and indirect linkages, the input-output multipliers quantify the change in each sector’s output that results from the complete cut in Russian energy inputs in trade partners’ industries and domestic sectors.

This approach, based on the pattern of energy use seen prior to the pandemic, suggests that a sudden stop in all imports of fossil fuels from Russia would affect all sectors of the economy, particularly energy-producing sectors, transport, minerals and metals manufacturing (Figure 1.25). Aggregating across sectors, the estimates imply a reduction in European output in manufacturing and market service sectors of between 2¾-3 per cent, if not offset by drawing down stocks or by substituting other energy inputs. Around one-half of this output decline would be due to shortfalls of petroleum and petroleum products, with the majority of the remainder from shortfalls of natural gas. These estimates highlight the risks of possible supply disruptions following an oil embargo, and the additional potential risks of a gas embargo.

These illustrative input-output estimates are highly uncertain, particularly given ongoing efforts to diversify sources of energy supply in Europe. The output effects could easily be understated, as supply disruptions could force companies to shut down production completely rather than reduce it proportionally. The near-term impact of a simultaneous sharp contraction in production across many sectors and countries is also likely to be larger than if only one country is affected. On the other hand, the input-output structure used cannot account for possible substitution effects with foregone Russian imports replaced by imports from elsewhere, or by drawing down reserves, using additional domestic supplies from alternative energy sources, such as nuclear energy or renewables, or improved energy efficiency. Such adjustments would mitigate the output costs.

Figure 1.25. Sizeable output declines could occur in some sectors in Europe if energy inputs from Russia were suddenly stopped

Percentage decline in manufacturing plus market services output

Note: See text for details of the calculations. Primary and secondary oil includes crude, natural gas liquids, refinery feedstock and other processed oil products.

Source: OECD Input-Output Tables (IOTs) 2021 database; IEA World Energy Balances database; and OECD calculations.

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A few similar studies report comparable output costs for Germany of between 0.3 and 2.2% (depending on the scenario considered) and slightly lower costs for France (Baqaee et al., 2022; Bachmann et al., 2022). Earlier estimates using input-output linkages also pointed to relatively small output costs in Europe if imports of natural gas from Russia were ended (Bouwmeester and Oosterhaven, 2017). In contrast, estimates by Holtemöller et al. (2022) and Deutsche Bundesbank (2022) for Germany highlight the risk of a large and immediate drop in output in the event of a sudden stop in energy imports from Russia.13

The extent to which the loss of imported fossil fuels from Russia can be offset will depend in part on the timing and circumstances of such a change.

• Strong drives to reduce Europe’s dependency on Russia over the course of this year have already begun. In early March, the IEA set out a plan to reduce use of gas from Russia by at least one-third in 2022. Shortly thereafter, the European Commission released its RePower EU plan, raising the ambition to a two-thirds cut within a year. Plans include improved storage levels ahead of the winter season, joint purchases from alternative suppliers, greater use of renewables and other existing domestic energy sources, and improved energy-saving measures (such as lower residential heating temperatures).

• There has already been a substantial shift in the composition of European gas imports this year. In the first 21 weeks of 2022, EU imports of Russian gas via pipeline were down by more than 30% compared to the corresponding period in 2021, and more than offset by a 54% increase in liquefied natural gas (LNG) imports from other sources. As a result, the share of Russian gas in total gas imports fell from 35% on average in the first 21 weeks of 2020 and 2021 to 24% in the same period of 2022 (Figure 1.26).

• The IEA has also produced a 10-point plan to reduce oil use. In addition to finding alternative suppliers, a key need is to change behaviour and reduce demand. Actions to lower the amount of oil consumed by cars are particularly important. These changes will take time to put into full effect, raising potential risks to the projections of a sudden stop in oil supplies in the absence of adequate storage levels.

• More generally, global energy markets are tight, although there is scope to obtain additional oil output from some OPEC and non-OPEC producers and further coordinated inventory releases by IEA members. Increased LNG deliveries can also help to mitigate any potential supply disruptions of pipeline gas to European markets, although additional investment in this sector will be necessary (G7, 2022). Significant logistical challenges also need to be overcome, including the transportation by sea of fuels from more distant non-European suppliers, the specialised platforms needed to store LNG offshore, and the infrastructure required to ensure that additional supplies can be moved within Europe to inland markets previously supplied by gas pipelines from Russia. Refineries currently designed to process oil from Russia also need to be reconfigured, unless a close substitute can be found. The difficulties that Russia would face in diverting all of its energy exports to Europe to non-European markets, particularly gas, would also be likely to hit global energy supply, at least in the short term. Strong additional competition from Europe for scarce energy supplies would therefore be likely to drive up prices in global markets.

Figure 1.26. The share of Russian gas in total European gas imports has already declined sharply

Share of EU gas imports, weeks 1-21

Source: McWilliams et al. (2021), based on data from ENTSO-G.

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Illustrative simulations, using the NiGEM global macroeconomic model, highlight the risk of potential adverse effects from an end to Russian gas imports in the European economies. A full gas embargo is modelled as a negative supply shock, with potential output in the average European economy lowered by close to 1½ per cent via a combination of reduced technical efficiency and a fall in average hours worked. The embargo is also assumed to push up global gas prices by 50%, reflecting the need for the European economies to source additional supplies on world markets and reduced supply from Russia.14 Higher gas prices are expected to also push up fertiliser prices, which are assumed to rise by 25%, and increased demand for energy supplies is expected to spill over into oil markets, with oil prices assumed to rise by 10%. Given the uncertainty that is likely to accompany energy supply disruptions, additional effects are likely to arise in the European economies from a decline in confidence and higher financing costs for companies. These effects are modelled by an ex-ante increase of 1 percentage point in the household saving rate and a 1 percentage point rise in the user cost of capital. The commodity price shocks are assumed to last for at least one full calendar year, before fading slowly as markets start to adjust. All other shocks are assumed to persist for three years before fading. Policy interest rates are endogenous and adjust according to the balance of the shocks to growth and consumer price inflation.15

• Taken together, these shocks could reduce growth in the European economies by over 1¼ percentage points in 2023, relative to baseline, and raise inflation by over 1 percentage point (Figure 1.27). A growth decline of this magnitude could potentially leave many countries close to, or in, recession in 2023. Growth would also be weakened in 2024 if the shocks persist, with demand gradually being brought into line with the reduction in supply. Real household disposable incomes would be hard hit, declining by more than 2% in the euro area economies, reflecting the drag exerted by higher prices and lower hours worked. Business investment would also be severely affected, with lower potential output, higher gas costs and the higher user cost of capital leading to declines of around 5% or more in many European economies in 2023.

• Outside Europe, the impact of the shocks would be smaller, especially in other gas-producing economies, but there would still be impacts from higher inflation on real incomes and weaker demand from Europe. For the world as a whole, inflation is pushed up by over ½ percentage point in 2023, with growth reduced by just under ½ percentage point.

• Monetary policy reacts to the upturn in inflation, with policy interest rates initially raised by around 50 basis points in the euro area in the first year of the shock, and 25 basis points in many other advanced economies, before returning towards baseline as inflationary pressures subside.

Figure 1.27. An embargo on gas supplies from Russia would hit growth and raise inflation in Europe

Note: Illustrative scenario of the impact of ending imports of gas from Russia in Europe. See text for details of the shocks considered.

Source: OECD calculations using the NiGEM macroeconomic model.

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In addition to energy, the risks of stronger costs from the war in Ukraine also arise from shortages of critical raw materials, and disruptions to transportation and trade finance.

• As Russia and Ukraine are important suppliers of many critical raw materials, the risks of disruption are also high for some supply chains relying heavily on these inputs (e.g. automobile, aeronautics or electronics). Substituting towards alternative sources of supply is particularly difficult for some critical raw materials provided by Russia and Ukraine as these inputs are highly specialised and the market is very concentrated (Box 1.4; Grzegorczyk et al., 2022).

Box 1.4. Potential disruptions in raw materials trade due to the war in Ukraine

The products most at risk of disruptions in supply from Russia and Ukraine can be identified using granular customs data. For the purposes of this analysis, a traded good is characterised as vulnerable to disruption if Russia or Ukraine is one of the top five world exporters and if their combined market share represents at least 15% of the global export market. Out of more than 4500 products traded in 2020, 92 are identified as vulnerable on this basis. Collectively, they represent 2.7% of the total value of trade in 2020 (Table 1.2). The vulnerable products are concentrated in metals, chemicals, food and agriculture.

This snapshot of potential vulnerabilities suggests that beyond the impact on agriculture (Box 1.1) and energy, there are risks that the war hits trade in raw materials and triggers ripple effects in critical industries. European gross exports of basic metals and fabricated metal products contain almost 10% of value added from raw materials that originate from Russia. This high degree of backward integration to Russian metals makes production throughout Europe sensitive to disruptions.

Table 1.2. The products from Russia or Ukraine most vulnerable to disruption
	Number of traded products	Total value (bn USD)	Number of products where Russia or Ukraine is a top-5 exporter	Number of vulnerable products	Share of vulnerable goods in % of total value of exports
Total	4528	16736	277	92	2.7
Agriculture	239	566	24	11	17.3
Food	424	1105	36	18	3.0
Chemicals	719	1420	59	18	3.0
Metals	577	1740	72	26	5.2
Mining and petroleum	106	1746	29	10	9.0
Others	2463	10158	57	9	0.4
Source: BACI database from CEPII; and OECD calculations.

Palladium and nickel matter for green technologies

Within metals products, Russia accounted for one-quarter of global palladium exports in 2020 (Figure 1.28, Panel A). This material is important for many green energy technologies. Its catalytic properties make palladium a central input for the production of emission-control systems in vehicles, with car manufacturers using it to remove toxic emissions from exhaust fumes. Global exports of nickel are also highly concentrated, and Russia together with Ukraine account for one-third of the world export market. Its uses include production of batteries powering electric vehicles. Ukraine is also a key exporter of neon gas, a by-product of steel manufacturing used in the lithography of semiconductors, which is sold to Korea, the United States, China and Chinese Taipei (Figure 1.28, Panel B). This collection of potential supply chain disruptions could pose significant risks for the vehicle industry, and especially the production of electric vehicles.

Figure 1.28. Russia and Ukraine are major suppliers of many metals

Note: Panel A shows the share of the top five exporters in global exports recorded in 2020 for each commodity. Panel B shows the destinations of Ukraine’s exports of rare gases (i.e. neon gas).

Source: BACI database from CEPII; and OECD calculations.

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Steel value chains are also at risk, with potentially widespread downstream propagation

War-related disruptions could also weigh on iron and steel trade. Many products belonging to the broad iron and steel category are dependent on Russian and Ukrainian exports (Figure 1.29). Russia and Ukraine account for one-quarter of global exports of iron and non-alloy steel semi-finished products, and half of world exports of pig iron. While iron and steel are more easily substitutable than rare metals (such as palladium), their widespread use in multiple downstream industries could trigger cascading consequences in the event of supply disruptions.

Russia is also a major exporter of ferro-alloys, supplying 30% of the global export market for ferro-tungsten, ferro-chromium and ferro-titanium. Stainless steel makers use these ferro-alloys as a stabiliser in the production of low-carbon steels. Chromium and vanadium are also two important inputs in steel production: a small quantity is enough to harden steel and make it very resistant. The stainless steel is then used in construction or automotive industries. Stainless steel is also an input in transportation, including ship containers for the transportation of chemicals, liquids and food products. Many renewable energy technologies also use stainless steel components as they can withstand corrosive environments.

Figure 1.29. Several iron and steel products from Russia and Ukraine are particularly vulnerable to disruption

Share of the export market, in percentage

Note: The product “iron or non-alloy steel” corresponds to “iron or non-alloy steel, semi-finished products thereof”.

Source: BACI database from CEPII; and OECD calculations.

 StatLink https://stat.link/u9wnxg

• Disruptions to transportation could also have long-lasting and deeper costs, and increase congestion in international shipping. Regional blockages arising from Russia and Ukraine could also have stronger ripple effects on freight traffic than seen so far. European firms relying on manufacturing goods produced and assembled in Asia are particularly under pressure, since this merchandise is usually shipped through Russia. Bypassing Russian airspace or ports increases costs and the time taken for deliveries.

• Financial sanctions on Russia could also magnify the trade fall by more than assumed in the projections, as has happened in the past. During the 2008-09 global financial crisis the collapse in exports in many countries was disproportionate to that of output, in part due to disruptions to trade credits. Exporting generally involves higher default risks and working capital requirements than domestic activity (Amiti and Weinstein, 2011), reducing the incentives of lenders to provide credit during crises. In the 2014 sanctions on Russia, the financial disruption to the provision of trade finance is also thought to have reduced trade (Crozet and Hinz, 2016).

Inflationary pressures could be stronger and longer lasting than expected

The prices of energy, metals and food commodities have relatively large weights in producer price indices (PPIs). As a result, across the OECD the PPI has risen much more sharply than consumer prices, although there is considerable cross-country variation (Figure 1.30). This is a common pattern, as the other cost components of consumer prices (especially labour costs) tend to be much less variable than commodity prices. Changes in producer selling prices are then passed through into retail prices, potentially with a lag, with the prices charged to consumers also reflecting distribution costs and retailers’ margins. Empirical estimates suggest that if PPIs were to continue rising in the coming months at a pace similar to that seen over the past year, consumer price inflation would be expected to rise further through 2022 in many economies (Box 1.5). Given the potential of the war in Ukraine to result in further upward pressure on a range of commodity prices, together with the possibility of additional supply chain disruptions arising from both the war and China’s zero-COVID policy, a continuation of inflationary pressure coming via producer prices is a clear risk.

Figure 1.30. Producer prices have risen more sharply than consumer prices

Change from April 2021 to April 2022

Note: Manufacturing producer prices in domestic markets. The consumer price index for euro countries and the euro area refers to harmonised price indices. The OECD aggregate producer price index is for March.

Source: OECD Database on Consumer Price Indices; OECD Database on Producer Price Indices; and OECD calculations.

 StatLink https://stat.link/q2ca59

Box 1.5. The pass-through from producer to consumer prices

The rapid rise of producer prices, especially for energy, has opened up an unusually large gap between producer price inflation and consumer price inflation (Figure 1.30). A key question is whether this presages continued upward pressure on the latter. The analysis in this box (developed in more detail in Ollivaud, 2022) suggests that changes in producer price indices (PPIs) explain much of the recent annual increase in consumer prices. Different scenarios for how PPIs may evolve in the coming months suggest that if they continue to rise at a similar pace to the past year, headline consumer price inflation in advanced economies would be expected to continue rising through the end of 2022 (except in the United States, where it would remain broadly flat). If, however, the increases in the PPI were to decline and turn negative, as has been the case after past inflation spikes, there would be a quick slowdown in headline inflation.

Empirical estimates, using seasonally-adjusted monthly data, suggest that consumer price inflation has typically reacted relatively quickly to PPI inflation: nearly a third of the deflation/inflation that producers face is passed through in two months to consumers, with most of the change happening in the same month. The relationship between producer and consumer prices is less robust using core rather than headline consumer price inflation, i.e. excluding energy and food products. In the United States, the euro area and the United Kingdom producer prices are found to have a much smaller effect on core inflation than on the headline measure, with Japan a notable exception. This suggests that much of the association between the PPI and consumer prices comes from the impact of fluctuations in food and energy prices – which are typically reflected relatively quickly in both price series.

An assessment of the recent performance of the estimated equations suggests that consumer price inflation over the past year has typically been somewhat stronger than would have been predicted from producer prices alone (using actual PPI data) (Figure 1.31). The gaps between actual and predicted inflation over the past year are relatively small in Japan and the euro area, but larger for the United States and the United Kingdom. This suggests that additional factors have been important in the latter countries. This could be for instance an increase in employment costs or services prices, with broader consumer price pressures than just those reflected in producer prices.

The estimated equations can also be used to illustrate the possible outcomes for consumer price inflation depending on two different scenarios for near-term PPI developments. First, in a continued-high-inflation scenario, the average month-on-month increase in the PPI is assumed to be equal to the average seen over the past 12 months. This corresponds to an annualised month-on-month increase of 18.5%, 17.4%, 8.2% and 11.7% for the United States, the euro area, Japan and the United Kingdom, respectively. In an alternative scenario, it is assumed that PPI increases will slow and then turn quickly negative, as has been the case when prices have spiked in the past.

• If producer prices continue to rise rapidly, as they have over the past year, the analysis suggests that in most cases headline consumer price inflation would continue its upward trend – towards 11½ per cent for the United Kingdom, 10¼ per cent for the euro area and 3½ per cent for Japan – though not in the United States, where it would hover around 6% (Figure 1.32, Panel A).

• The alternative scenario where PPI inflation slows and then turns is characterised by a declining consumer price inflation rate (Figure 1.32, Panel B). Nonetheless, inflation would still remain above central bank target rates by the end of 2022, except in Japan.

Figure 1.31. The behaviour of the PPI over the past year explains much of current headline inflation

Year-on-year percentage changes in consumer prices

Note: Inflation for April 2022 for the United States and Japan, and March for the euro area and the United Kingdom. Predicted inflation comes from dynamic forecasts from April 2021 using estimated equations for consumer price inflation that relate month-on-month price changes to month-on-month producer price changes, using seasonally-adjusted series. Further details are provided in Ollivaud (2022). Consumer prices correspond to the personal consumption expenditures deflator for the United States, the harmonised consumer price index for both the euro area and United Kingdom, and the consumer price index for Japan.

Source: OECD Database on Consumer Price Indices; OECD Database on Producer Price Indices; and OECD calculations.

 StatLink https://stat.link/ayjgfl

Figure 1.32. The outlook for consumer price inflation depends on the evolution of producer prices

Year-on-year percentage changes in consumer prices

Note: Paths for consumer price inflation based on dynamic forecasts from estimated equations using monthly seasonally adjusted data; see Ollivaud (2022). The “High PPI inflation scenario” assumes that the monthly increase in PPI inflation until December 2022 remains at the average over the last 12-months of historical data. The “Low PPI inflation scenario” assumes that the monthly increase in PPI inflation converges gradually to -1% (monthly rate) from its current rate. On a monthly basis, PPI inflation would then become negative from June in the United States and the euro area, and from May in Japan and the United Kingdom. The producer price index is for manufacturing: total producer prices for the United States; domestic producer prices for the euro area, Japan and the United Kingdom. See Figure 1.31 for definition of consumer prices.

Source: OECD Database on Consumer Price Indices; OECD Database on Producer Price Indices; and OECD calculations.

 StatLink https://stat.link/6ow5cq

A further key area of uncertainty for the macroeconomic projections, as well as for policymakers, is the extent to which the burst of inflation that has already occurred gives rise to second-round effects, via expectations and labour markets, such that inflation becomes entrenched at above-target levels. Households’ near-term inflation expectations have moved up in many economies, although other measures of expectations are more mixed (Figure 1.33). In most OECD economies with available survey measures, the inflation expectations of professional forecasters have remained close to central bank objectives (including the euro area and Canada) or below (Japan), but there has been some sign of upward drift in the United Kingdom and the United States. Financial market measures of inflation expectations (5-year, 5-year forward inflation swaps or long-term differentials between nominal bond yields and yields on inflation-linked bonds) began to drift up in 2021 and have continued to rise slowly (Figure 1.33, Panel B).

Tight labour markets could generate stronger wage growth than anticipated, especially for workers willing to change jobs and in sectors most affected by the pandemic. The risks of strong wage growth are acute in the United States (Domash and Summers, 2022), with median annual wage growth as measured by the Federal Reserve Bank of Atlanta having already risen to above 6% in April. With the current surge in inflation having resulted in a sharp and unanticipated decline in real wages, attempts to recoup these losses can be expected in wage bargains. Wage growth has started to pick up in the euro area, with area-wide negotiated wages rising by 2.8% over the year to the first quarter of 2022, and by 4% in Germany (incorporating one-off adjustments). Corporate surveys also point to a gradual pick-up as demand tightens (ECB, 2022), although household survey indicators of wage expectations have yet to show a marked acceleration in expected wage increases. Minimum wage increases are adding to aggregate wage growth, especially in Europe, with rises over over 6% likely in the EU in 2022, and particularly large increases in Germany, Greece, Hungary and the Baltic States (Eurofound, 2022).

Figure 1.33. Household inflation expectations have risen but financial market measures generally remain better anchored

Source: Refinitiv; and OECD calculations.

 StatLink https://stat.link/iy9vm8

Potential vulnerabilities in financial markets and emerging-market economies during policy normalisation

Higher policy interest rates, along with global inflationary pressures and a deteriorating growth outlook, could expose the vulnerabilities that have built up from higher debt and elevated asset prices. Rising financing costs, in particular, could affect the repayment capacity of firms and households in the medium term. Tighter global financial conditions and higher risk aversion, in tandem with the impacts of the war in Ukraine, also aggravate potential vulnerabilities in emerging-market economies from rising interest rates and capital flow reversals. Among the latter, commodity-importing economies face heightened fiscal and current account risks from higher global commodity prices.

Corporate indebtedness continued to rise in 2021 in many countries. In the median OECD economy, the debt of non-financial firms reached 106% of GDP in the third quarter of 2021, 15 percentage points above the 1999-2019 average. Tightening financing conditions and the progressive removal of many pandemic-related support measures, such as credit guarantees, raise concerns about corporate debt sustainability even though vulnerabilities have so far been contained. Financing costs for most companies in the largest economies have increased recently but are still moderate (Figure 1.34, Panel A), and debt service ratios remain close to, or below, their historical averages (Figure 1.34, Panel B). Healthy balance sheets and a substantial slowdown in financing needs in 2021 (after a record year in corporate loan and bond issuance in 2020) also limit immediate default risks. Firm-level data show that non-financial companies have started unwinding the very large cash buffers accumulated during the pandemic, but the amount of liquidity on large corporates’ balance sheets is still substantially higher than in the fourth quarter of 2019.16 Many large corporations also took advantage of low rates and quantitative easing during the pandemic to refinance their debt and lengthen its maturity, which will delay the speed at which higher market interest rates are reflected in debt service burdens. In the United States and Europe, the bulk of non-financial companies’ debt is currently set to mature between 2026 and 2028.17

The risk of default for the most fragile firms currently appears contained, but concerns remain. As of the fourth quarter of 2021, the corporate default rate among speculative issuers in the United States – firms with the lowest rating – was still historically low (1.5%), and the median interest coverage ratio (ICR) among firms in this category remained higher than before the pandemic (S&P Global, 2022b). However, the resilience of the most vulnerable firms will ultimately depend on the growth and inflation outlook. Declines in household purchasing power or new COVID-19 variants could hurt sectors such as media and entertainment and consumer products disproportionately.18 Larger-than-expected increases in interest rates could also hamper the ability of financially-stressed firms – those with ICR ratios close to or below one – to service their debt.19 The conflict in Ukraine is also likely to weigh on firms’ access to finance.20

Figure 1.34. Corporate debt sustainability metrics are still favourable

Note: IG and HY refer to Investment Grade and High Yield bonds, respectively.

Source: BIS Credit Database; ICE BofA Indices database; and OECD calculations.

 StatLink https://stat.link/wxplm6

There are also risks that debt service burdens could rise sharply for households. Household debt rose during the pandemic in most OECD countries (Figure 1.37, Panel A), but aggregate household balance sheets are generally healthier than they were before the pandemic, partly due to the savings accumulated in 2020 and 2021 (Figure 1.37, Panel B). Between 2019 and the third quarter of 2021, the aggregate financial net worth of households, measured relative to gross disposable income (GDI), rose by roughly 20 percentage points in the median OECD country. The sensitivity of debt service burdens to interest rates is also limited by the high share of fixed interest rates mortgages in many markets (Box 1.6). However, rising mortgage rates still carry a risk, especially for low-income borrowers in countries where monetary policy could be tightened more aggressively. With housing demand slowing due to the rise in longer-term financing costs, house prices are more likely to stabilise and could even adjust downwards. In this context, further steps could be taken to strengthen macroprudential tools to address risks to households and banks in the housing market (Box 1.6).

Box 1.6. Vulnerabilities in the housing sector from rising mortgage rates

House prices, along with household debt, rose steadily throughout the pandemic, even in countries in which valuations were already stretched and debt levels already high. With monetary policy now beginning to normalise, mortgage rates are increasing in many OECD countries, raising solvency concerns. However, vulnerabilities appear contained at present due to households’ relatively strong balance sheets and the limited use of adjustable-rate mortgages (ARM). Still, fragile borrowers could be at risk in economies where ARM dominate, debt-service ratios are high and monetary policy is likely to tighten substantially. The potential adverse consequences for households and financial system resilience of a sharper-than-expected house price reversal also need to be prevented, primarily by macroprudential policy tools.

The pandemic pushed house prices to new heights in many countries

House prices rose strongly and quickly in most OECD countries during the pandemic. Between the fourth quarter of 2019 and the fourth quarter of 2021, real house prices rose by 13% in the median OECD economy (Figure 1.35). On average across countries, real house prices in the fourth quarter of 2021 were about 4% higher than expected based on the underlying trend prevailing before the COVID-19 pandemic, suggesting that the pandemic has exacerbated pre-existing tensions in many housing markets.1 A range of factors can explain this strong and synchronised response of house prices. Exceptionally accommodative monetary conditions, a surge in household savings and unprecedented fiscal support all boosted housing demand during the pandemic, with housing supply temporarily curtailed by mobility restrictions and logistical bottlenecks. Higher financing costs should moderate future housing demand, helping the rise in house prices to abate. A slowdown is already taking place in several key markets, such as the United States, with home sales and prices stabilising or even declining in some large cities, due to rising mortgage rates.2

Figure 1.35. Real house prices rose strongly in OECD countries during the pandemic

Note: The real house price gap represents the percentage gap between house prices in 2021 Q4 and the country-specific trend estimated for each country by an HP filter. The latter is a proxy of the level house prices would have reached had the pandemic not happened. The real house price index is the ratio of the nominal house price index to the deflator of private consumption in each country. A related measure is proposed as an early warning indicator of financial vulnerabilities by Hermansen and Röhn (2016).

Source: OECD Analytical House Price database; and OECD calculations.

 StatLink https://stat.link/1mbcra

Fixed-rate loans dominate the mortgage landscape

The exposure of households to rising mortgage rates will be damped by the limited use of flexible or adjustable rate mortgages (ARM) in many OECD countries (Figure 1.36, Panel A), although there are also differences across countries in the typical period for which interest rates are fixed (van Hoenselaar et al., 2021). With the exception of Japan and, to some extent, Spain, the largest mortgage markets in advanced economies are heavily dominated by fixed-rate mortgages. In contrast, ARM contracts, which have been shown to be associated with a higher probability of default on mortgages when interest rate rise (Gross et al., 2022),3 are prevalent in several countries in Southern (Portugal and Greece), Eastern (Poland, Bulgaria, Romania and the Baltics) and Northern Europe (Sweden, Finland and Norway). If monetary policy normalisation proceeds gradually, borrowers should be protected from a sharp increase in financing costs over the medium term. Financially fragile borrowers in countries with independent monetary policies and rising inflation pressures could nonetheless experience a substantial rise in their debt servicing costs, particularly in countries where the ratio of mortgage costs to disposable income is already high for the lowest income quintile (van Hoenselaar et al., 2021).

Households’ savings are high and debt service ratios are still low

Household balance sheets are currently stronger than before the global financial crisis (GFC) in many countries. Stronger regulation in the aftermath of the GFC has limited the amount of risk-taking in the household sector over the last decade. In addition, the recent rise in household debt has been matched by a significant rise in household savings during the pandemic. These savings should support the repayment capacity of many households exposed to adjustable rates, especially if interest rates were to increase more rapidly than expected. Moreover, the low interest rate environment is still keeping average debt service ratios (DSR) in the household sector close or even below their long-term norms (Figure 1.36, Panel B), and significantly below what is considered a stressed DSR.4 However, aggregate numbers might conceal important heterogeneity, and risks remain that the repayment capacity of low-income borrowers could deteriorate, given the withdrawal of pandemic income support measures and higher inflation.5

Figure 1.36. Fixed-rate mortgages and moderate debt service ratios limit risks in housing markets

Note: The level of household credit is measured as of 2021 Q3, and the average share of ARM at issuance in 2019 and 2020 is used to proxy for the importance of each type of mortgage in each country.

Source: European Mortgage Federation; Australian Bureau of Statistics; Mortgage Professionals Canada; Japan Housing Finance Agency; US FHFA, National Mortgage database; BIS Credit Database; and OECD calculations.

 StatLink https://stat.link/02cz5k

Macroprudential policies could be strengthened further

Real estate prices might adjust more abruptly. A sharp deterioration in the growth outlook, or a sudden increase in inflationary pressures, could accelerate a correction in housing markets, with potentially damaging consequences for households’ and banks’ balance sheets. Given the large uncertainty surrounding the outlook, it is critical that there are adequate buffers in the banking sector to ensure resilience to unexpected fluctuations in property markets.

Most countries already have policies in place to limit over-indebtedness and associated risks. Following ESRB recommendations (ESRB, 2022), many European countries have recently announced increases in their countercyclical buffer (CCyB) after some relaxation during the pandemic, including some measures explicitly targeting risks in the real estate sector. For instance, Germany’s financial regulator, BaFin, proposed in January 2022 to (i) raise the countercyclical buffer on banks’ domestic exposures to 0.75% of risk-weighted assets (RWAs) from 0% and (ii) to apply an additional systemic risk buffer of 2% of RWAs specifically targeted at residential real estate mortgage loans

Preventive measures to limit further price increases, such as additional steps to lower LTVs or DSTI ratios, might also be welcome to moderate risks. Some countries have already taken steps to tighten existing tools to moderate new housing loans, while others could consider implementing those tools.6 In addition to these macroprudential instruments, reforms in rental regulation and property taxation may also be effective means of addressing housing pressures over time. Those tools, along with stronger public investment in social housing and potential land use reforms, especially in job-rich urban areas, could ease the tensions that are still likely to prevail in the medium term (OECD, 2021b). Although the supply of new construction slowed down only moderately during the pandemic, new housing permits and starts dropped significantly in many OECD countries.7 This gap, along with ongoing supply bottlenecks and labour shortages, is likely to amplify the structural housing shortages affecting many countries.

← 1. Price-to-rent and price-to-income ratios were already pointing to stretched housing valuations in many OECD countries before the pandemic and reached historic highs in almost all countries in early 2021.

← 2. In the United States, the Mortgage Bankers Association’s Purchase Index, which tracks mortgage applications, fell 15% year on year during the week ending May 13, with mortgage interest rates having risen by 2 percentage points over the same period. In most countries, the rise in mortgage rates is not yet visible in official statistics because of reporting lags. House price growth also moderated in the first quarter of 2022 in Australia, and the Reserve Bank of Australia (2022) has estimated that a 200 basis point increase in interest rates would result in real house prices falling by around 15% over a two-year period. In Canada, mortage rates are expected to have an immediate impact on new homebuyers and only a gradual one on existing homeowners (Kozicki, 2022).

← 3. Gross et al. (2022) assess the sensitivity of household mortgage probabilities of default (PD) and loss given default (LGD) to changes in unemployment, house prices and interest rates using data from 21 EU countries and the United States, and find that the PDs are much more sensitive to changes in short-term interest rates in countries with a high share of ARMs.

← 4. The notion of a stressed DSR varies across countries, but a debt service ratio above 40-50% is often considered as stressed (ESRB, 2022). The DSR data provided by the BIS (Figure 1.36) cover all types of household debt and should therefore be interpreted as an upper bound of the true mortgage repayment burden.

← 5. Emerging-market economies face tighter fiscal constraints than advanced economies, making it more difficult to put in place fiscal measures to mitigate the economic impact of the COVID-19 pandemic. This has led to a further increase in household debt. With household debt standing at 50% of GDP, emerging-market economies now have about the same levels of leverage as advanced economies had in 2001, just a few years before the global financial crisis, and substantial interest rate increases to address inflation are being implemented.

← 6. Austria’s Financial Market Stability Board (FMSG) asked the country’s bank supervisor and central bank in December 2021 to make its sustainable mortgage lending guidance legally binding by mid-2022. The guidance was issued in 2018 and includes a minimum down payment of 20% (equivalent to an 80% loan-to-value (LTV) cap), a debt-service-to-income (DSTI) ratio of no more than 40% and a maximum loan term of 35 years, except in exceptional circumstances. Germany could also consider formally implementing LTV and DSTI ratios, which are still missing despite the establishment of a legal framework for borrower-based instruments in 2017 (ESRB, 2022).

← 7. Housing permits in 2020 dropped by roughly 15%, on average, compared to 2019 in a sample of the largest OECD economies. Although in most countries permits bounced back to pre-pandemic levels in 2021, the gap in new constructions has not yet been fully offset. This will negatively affect the total supply of new homes available over the next few years.

Figure 1.37. Household debt and net financial worth in selected OECD countries

Note: In Panel A, the latest available observation for Korea is 2021 Q3.

Source: OECD National accounts database; OECD Household Dashboard; and OECD calculations.

 StatLink https://stat.link/t9u6pq

The war in Ukraine exacerbates vulnerabilities in many emerging-market economies

The Russian invasion of Ukraine has further tightened financial market conditions for commodity-importing economies and heightened concerns about emerging-market economy vulnerabilities to scarcer and more expensive financing. Higher commodity prices also compound the challenges from pre-existing inflationary pressures and put further pressure on fiscal and current account balances in commodity-importing economies (Box 1.1). Pandemic risks also linger, amidst an uneven pace of vaccination across countries and regional COVID-19 outbreaks. Emerging-market economies also remain vulnerable to capital outflows from faster and more extensive policy interest rate rises in advanced economies.

When the war in Ukraine broke out, local-currency government bond yields surged in all regions accompanied by an abrupt repricing in equity markets, reflecting a generalised increase in risk aversion. Tighter global financial conditions have also increased financial market volatility in emerging-market economies. In particular, local-currency government bond spreads have remained high in many countries, except in Asia, amid currency depreciation pressures (Figure 1.38, Panel A). Foreign-currency bond spreads have recently exceeded 10 percentage points in almost a quarter of a larger set of emerging-market and developing economies (IMF, 2022a), indicating significant sovereign borrowing difficulties. Equity prices have declined sharply in Asia, reflecting concerns about China, and been volatile in other major emerging-market economies (Figure 1.38, Panel B).

Figure 1.38. Bond and equity markets reflect substantial repricing across emerging-market economies

Note: Panel A shows the yield differential between 10-year local-currency government bonds in emerging-market economies and 10-year US Treasuries. Aggregate spreads correspond to unweighted cross-country averages. The regional equity indexes shown in Panel B are obtained by first converting individual local-currency indices to dollars and then aggregating them based on their market capitalisation weight. The shaded area in both panels denotes March 2020. The vertical line in both panels denotes 24 February 2022. “EME – Europe” covers Bulgaria, Romania and Türkiye. “EME – Asia” covers China, Indonesia, India, Malaysia, the Philippines, Thailand and Vietnam. “EME – Latin America” covers Brazil, Chile, Colombia and Mexico. The “EME” aggregate covers all these countries plus Russia and South Africa. Both panels show 10-day moving averages.

Source: Refinitiv; and OECD calculations.

 StatLink https://stat.link/hn9o4w

Elevated public and private debt levels and a high share of foreign-currency liabilities aggravate vulnerabilities to rising interest rates and capital flow reversals. Prior to the war in Ukraine, total debt as a share of GDP was gradually declining in the major emerging-market economies, helped by the larger-than-anticipated increase in inflation.21 Nonetheless, the ratio of total debt to GDP, and in particular government debt to GDP, often remains well above pre-pandemic levels (Figure 1.39, Panel A). Emerging-market and developing economies issued around USD 3.5 trillion of sovereign debt in 2021, almost 40% higher than the average annual amount issued in 2017-19 (OECD, 2022b).22 The share of foreign-currency debt in new issuance has declined considerably in Latin America and the Middle East-North Africa region, suggesting that governments have focused on domestic markets amid rising external borrowing costs. However, with high government debt typically associated with a larger share of the government in total banking sector claims, this could hamper the access of private sector borrowers to credit (Figure 1.39, Panel B). The overall share of central government debt denominated in foreign currency also remains high in Argentina, Bulgaria, Romania and Türkiye, ranging between 50 and 70%. Should capital outflows from emerging-market and developing economies intensify, resulting in further currency depreciation, the debt burdens of those countries could increase significantly. Sovereign default risks, which have already materialised in Lebanon and Sri Lanka, are heightened by the sizeable (one third) share of variable-rate debt in the total external debt of the poorest countries (Estevão, 2022).

Figure 1.39. High public debt in emerging-market economies restrains lending to the private sector

Note: In Panel A, debt comprises loans and debt securities, and GDP takes the sum of the four quarters finishing in the quarter debt referred to. In Panel B, for Russia, local-currency claims on all sectors in 2021Q3 are used in the denominator due to missing data; for the remaining countries, claims on non-banks denominated in all currencies are used. Bank claims on the private sector in Panel B are calculated by subtracting bank claims on general government (collected from the IMF Sovereign Debt Investor Base database) from all claims on non-banks (collected from the BIS credit statistics except for Türkiye). General government debt in Panel B follows the definition in the IMF Sovereign Debt Investor Base database and excludes intergovernmental debt.

Source: OECD Economic Outlook 111 database; BIS credit statistics; IMF Sovereign Debt Investor Base for Emerging Markets database; Banking Regulation and Supervision Agency in Türkiye; and OECD calculations.

 StatLink https://stat.link/flwyxm

Broad-based commodity price increases and weaker growth in major export markets add to existing macroeconomic vulnerabilities in many emerging-market economies (Figure 1.40). Higher food and energy prices raise external deficits in many countries, and disruptions to agricultural exports from Russia and Ukraine heighten food security risks if alternative suppliers cannot be found (Box 1.1). Weaker growth in the euro area – a major export market – is adding to the immediate costs from exposure to Russia in countries like Bulgaria, Egypt, Romania and Türkiye (Figure 1.40, Panel C). Similarly, the gradual slowdown in the United States creates headwinds for growth in Mexico and other Latin American economies.

Figure 1.40. Commodity price shocks may worsen imbalances in some emerging-market economies

Note: Fiscal balance refers to central government net lending for Chile and general government net lending for the remaining countries.

Source: OECD Economic Outlook 111 database; IMF Direction of Trade statistics; IMF World Economic Outlook database; and OECD calculations.

 StatLink https://stat.link/xzyjp3

Preserving international co-operation would help overcome the pandemic and global challenges from the war

The COVID-19 pandemic is not yet over, with risks remaining that further variants of concern could emerge. Vaccination efforts are continuing around the world, but remain limited in many countries. Only 11% of the population in low-income countries are fully vaccinated, compared with over 70% in high-income countries (WHO-World Bank, 2022). The recovery will remain precarious in all countries until vaccination levels can be raised and test and treatment capacities are improved. Global vaccine supply shortages have now largely been addressed, but effective multilateral actions are required to help overcome domestic logistical hurdles to vaccine deployment by providing technical and financial assistance, reducing regulatory barriers on vaccines and other medical products, and by keeping borders open.

Cross-country engagement and actions also remain vital to address the challenges arising from the war in Ukraine, including overcoming disruptions and supply constraints in energy and food markets, and providing humanitarian assistance to those displaced by the war. Developing economies are particularly exposed to these challenges, which come on top of the persisting scars from the pandemic in many of them. Open and accessible markets, provision of financial assistance to the most vulnerable countries and populations, and multilateral measures to maintain liquidity in global financial markets and provide effective debt relief to lower-income countries are essential to help promote a sustainable recovery in all countries. Preserving and strengthening international co-operation would also help countries progress faster towards national COP26 objectives to mitigate climate change. The Inclusive Forum on Carbon Mitigation Approaches proposed by the OECD would provide a comprehensive inventory of policy actions and best practices worldwide, and help to compare the effectiveness of policies in different country circumstances.

The war in Ukraine is also adding significantly to pre-existing food security issues. Prior to the war, over 800 million people worldwide were already estimated to be facing hunger (FAO, 2021), with the numbers rising due to the impact of other conflicts, climate change and the pandemic. Ongoing disruptions to agricultural exports from Russia and Ukraine could result in serious shortages in many developing economies, especially in Africa and the Middle East and Central Asia, and exacerbate food price increases that are already weighing on vulnerable social groups. The food supply shock could be further compounded by fertiliser shortages (Box 1.1). To monitor and mitigate such risks, co-ordinated actions are needed urgently to provide emergency food supplies and the assistance necessary to facilitate crop planting and transportation, including in Ukraine, tackle logistical barriers limiting the supply of food to importing economies, and refrain from export restrictions of food and other agricultural products.

The pace of monetary policy normalisation should vary across economies

The impact of the war in Ukraine has added to the difficult choices already facing monetary policymakers. Ahead of the invasion, inflationary pressures were already proving stronger and more persistent than anticipated, albeit to a different extent and for different reasons across the major advanced economies. Recent months have thus seen steps towards monetary policy normalisation by many central banks. Policy interest rates are now being increased in a growing number of major economies, and net asset purchases have been halted or further reduced in most jurisdictions (Figure 1.41). Several central banks have also started to discuss or implement strategies for balance sheet reduction, either passively (by not reinvesting the proceeds of maturing bonds) or actively (through asset sales). In most jurisdictions, these changes could proceed more rapidly than expected in the event of further upside inflation surprises or stronger signs of a durable rise in underlying cost and price pressures.

• In the United States, the Federal Reserve began to increase the target for the federal funds rate in March. As of June, the Federal Reserve is also starting to reduce its holdings of Treasury securities, agency debt and agency mortgage-backed securities by reinvesting principal payments only if they exceed a monthly cap.23

• The ECB ended net asset purchases under the Pandemic Emergency Purchase Programme in March, and has signalled that it expects those under the remaining Asset Purchase Programme (APP) to be concluded early in the third quarter of 2022.

• The Bank of England, the Bank of Canada and the Reserve Bank of Australia have ceased to reinvest the proceeds of maturing bonds in recent months and have all raised their main policy rates.

Figure 1.41. Quantitative tightening has started in some countries

Central banks’ net bond purchases in advanced economies

Note: For Canada and New Zealand, latest available data are for April 2022. Data covers both private and public assets. Private assets include corporate bonds, commercial paper, asset-backed securities and exchange traded funds. General government bonds are treasury bills and municipal, state and central government bonds.

Source: Reserve Bank of Australia; Bank of Canada; Bank of England; European Central Bank; Bank of Japan; Reserve Bank of New Zealand; Sveriges Riksbank; US Federal Reserve; and OECD calculations.

 StatLink https://stat.link/8jcb0p

Given the uncertain duration and magnitude of the adverse supply shock from the war, and above-target inflation, monetary policy should remain focused on ensuring well-anchored inflation expectations and intervene if necessary to ensure the smooth functioning of financial markets and transmission of monetary policy. Central banks will have to conduct a delicate balancing act between keeping inflation under control and maintaining the post-pandemic economic rebound, especially where the recovery is not yet complete. The case for a steady policy tightening is stronger in those economies, such as the United States or some central European countries, where the recovery from the pandemic is essentially complete and signs of excess demand and durable inflation pressures were already apparent before the most recent commodity price surge. In contrast, removing accommodation more gradually is appropriate in countries where core inflation is moderate, wage pressures have yet to pick up and the growth outlook has deteriorated considerably because of the Ukraine conflict. Transparency and clarity in central bank communication will be critical. Increases in policy interest rates should remain data-dependent so that central banks can respond to unexpected developments in activity and labour markets, financial conditions and the broader inflation outlook without endangering financial stability. The importance of data-dependence is greatest in the economies most affected by the war in Ukraine.

Monetary policy normalisation is projected to continue over the next 18 months in most jurisdictions, at a faster pace than anticipated in late 2021 (Figure 1.42). However, its speed and strength are expected to vary widely across regions, given the different prospects for inflation and growth. The advanced economies differ substantially in terms of domestic underlying macro-economic conditions and exposure to external shocks such as the war in Ukraine. This heterogeneity, combined with exceptionally large uncertainty surrounding the growth and inflation outlook, translates into very different paths for monetary policy:

• In the United States, where the recovery is well advanced, and core inflation is over 5%, the federal funds rate is projected to be raised swiftly to 2¼-2½ per cent by end-2022 and to 3-3¼ per cent by end-2023. The reduction in asset holdings is expected to proceed steadily over the projection horizon by reinvesting payments from maturing securities only partially. Long-term interest rates on government bonds are also projected to tighten, reaching 3.8% by end-2023.

• In the euro area, net asset purchases are projected to end early in the third quarter of 2022, with the deposit rate raised from -0.5% to 1% by the second quarter of 2023 and the main refinancing rate raised from 0% to 1.5%. Maturing bonds are expected to be fully reinvested over the projection period, keeping the size of the ECB’s balance sheet unchanged. The ECB should make use of all margins of flexibility when reinvesting the proceeds of maturing bonds, particularly assets acquired under the pandemic emergency purchase programme, to limit financial fragmentation in the euro area.

• With Japan facing still-mild underlying inflationary pressures and only a small direct exposure to the Ukrainian conflict, the Bank of Japan is projected to maintain its current accommodative stance focused on yield curve control over the projection horizon, with no change in policy rates being assumed.

• Other major central banks are expected to tighten their policy stance further over the projection horizon, albeit at a different pace and with different end-points. The Bank of England is projected to increase its policy rate to 2.5% by mid-2023 and to continue to reduce the size of its balance sheet. The Bank of Canada is assumed to raise its policy rate steadily to 2.5% by early 2023, and to continue passive quantitative tightening throughout the projection period.

Figure 1.42. Monetary policy normalisation is gathering pace

Note: In Panel A, lines report the rate for the median advanced economy (AE). AEs include Australia, Canada, the Czech Republic, Denmark, the euro area, Hungary, Iceland, Israel, Japan, Korea, New Zealand, Norway, Poland, Sweden, Switzerland, the United Kingdom, and the United States. Short-term interest rates refer either to the 3-month money market rate or the 3-month treasury bill rate, depending on the country.

Source: OECD Economic Outlook 111 database; OECD Economic Outlook 110 database; and OECD calculations.

 StatLink https://stat.link/rckfj1

The scale and impact of quantitative tightening (QT) plans remain uncertain. Most central banks have, or will soon have, ended asset purchases, and many have begun to stop reinvesting the proceeds of maturing assets, but few have yet indicated whether assets will be sold actively or communicated the terminal size of their balance sheets. The main economic impact of quantitative easing has occurred through reductions in bond yields and increases in asset prices. Quantitative tightening is likely to reverse this, with some upward pressure on bond yields and downward pressure on asset prices, particularly if active asset sales take place. The extent of such adjustments will depend on whether asset disposals occur in a gradual and predictable manner, as planned by the major central banks, and the overall scale of balance sheet reduction.

Nonetheless, the impact of reductions in the balance sheet may be smaller than the past impact of asset purchases (Pill, 2022). Discretionary asset reductions imply that financial markets are functioning well (as they would not occur otherwise), whereas the benefits of QE have arisen partially from improvements in market liquidity at times when financial markets were not functioning smoothly. QE policies also had significant effects by signalling the implementation of a more accommodative monetary policy stance at a time when policy interest rates were at or close to their effective lower bound. This signalling channel is likely to be less important during QT, with increases in policy interest rates and their future expected path used as a timely and clear signal of a change in the monetary policy stance. Normalisation strategies may however still vary across economies. In contrast to the United States, monetary policy in the euro area will have to be mindful of fragmentation risks, and take steps to address these if necessary, since QT announcements might tighten the monetary stance disproportionately in some economies.24

Fiscal policy support should be contingent on the state of the economy

Fiscal consolidation plans for the current year have been reconsidered in many countries due to the war in Ukraine and soaring energy prices. Countries have continued to withdraw pandemic-related support measures, but also are addressing new immediate budget priorities. These tend to be more acute in Europe, including the costs of shielding households and companies from surging energy and food prices (discussed below) and of providing for Ukrainian refugees. The latter costs are highly uncertain, but available estimates point to amounts of around 0.2% of EU GDP in 2022 (Box 1.2), largely financed by EU funds. With a few exceptions, such as Poland and some Baltic countries, national Stability or Convergence Programmes suggest similar or even smaller estimated costs.

Fiscal projections for 2022-23 are conditional on announced government measures and OECD assessments of current plans (Annex 1.A.). In the median OECD economy, the fiscal stance is estimated to be broadly neutral in 2022, with the underlying primary balance increasing by 0.2% of potential GDP in 2022, before rising by 0.7% in 2023 (Figure 1.43). Relative to expectations in late 2021, this implies a considerable slowdown in the pace of consolidation in the current year:

• In the United States, fiscal policy assumptions are based on legislated measures only and imply substantial fiscal tightening, with the underlying primary balance projected to improve by over 6% of potential GDP over 2022-23. The withdrawal of pandemic-related support measures, many of which expired in the course of 2021, is expected to outweigh the additional public investment in 2022-23 under the Infrastructure Investment and Jobs Act.

• In the euro area, the fiscal stance is projected to remain broadly neutral in 2022. The unwinding of measures introduced during the pandemic is expected to be offset by support for energy consumers and refugees and stimulus from the implementation of Next Generation EU (NGEU) plans. The projected overall absorption of NGEU grants until the end of 2023 remains in line with expectations in late 2021, exceeding 0.5% of euro area GDP in 2022-23. In 2023, fiscal consolidation of 0.8% of potential GDP is expected, mainly driven by the withdrawal of support to energy consumers and the full termination of COVID-19-related measures (which sometimes were still in force in early 2022).

• In Japan, the fiscal projections reflect the economic package announced in late 2021 and legislated in the FY2021 supplementary budget and the FY2022 initial budget, complemented by more recent temporary measures to support vulnerable households and businesses. The ensuing discretionary fiscal expansion, estimated at close to 2% of potential GDP in 2022, is expected to be largely reversed in 2023 as the stimulus measures expire.

Figure 1.43. New budget priorities have often moderated consolidation efforts

Change in the underlying primary balance, in per cent of potential GDP

Note: Vertical lines indicate the median for the available OECD economies.

Source: OECD Economic Outlook 111 database; and OECD calculations.

 StatLink https://stat.link/yq2gij

In the short term, fiscal policy should tackle the adverse distributional impacts of higher energy prices whilst avoiding adverse effects on the sustainability of the public finances or the transition to carbon neutrality. Given the acceleration of energy prices this year, countries, especially in Europe, have put in place a wide range of measures to support energy consumers (Figure 1.44), with budget costs in 2022 projected to exceed 1% of GDP in France, Germany and Italy. To help finance those costs, a number of European countries have enacted windfall profit taxes on energy companies. Policy action to help cushion the impact of higher energy prices should be well-targeted, not outlast the period of exceptional price pressures and avoid weakening price signals. Additional means-tested transfers to households while high prices persist generally meet these criteria, though finer targeting mechanisms that go beyond income, should be developed (OECD, 2022c). In contrast, lower taxes on energy or price controls, which have been the most widely used forms of support, tend to be untargeted. These measures are often administratively simpler and faster to implement, and help preserve aggregate household disposable income, an appropriate policy goal in economies where demand is still recovering from the pandemic. However, untargeted price support should not stay in place for more than some months due to the high fiscal costs involved and the need to avoid damaging incentives to reduce energy consumption and undertake the investments required to improve energy efficiency and develop alternative sources of energy.

Figure 1.44. Support to energy consumers has been widespread and diverse

Number of countries adopting each type of support measure

Note: The figure is based on data collected for 35 OECD member states plus Bulgaria, China, India and Romania up to 30 May 2022. Support measures fall under two categories: income support (including lump-sum transfers to consumers) and price support measures, which lower energy prices paid by consumers. For income support, 'Other' includes loan guarantees for energy companies. For price support, 'Other' includes energy market regulatory changes. Targeted measures resort to means-testing or benefit only certain categories of consumers based on their energy consumption and other criteria. Non-targeted measures apply to all consumers with no eligibility conditions.

Source: OECD calculations.

 StatLink https://stat.link/bainuw%20

Fiscal policy should also take account of potential interactions with monetary policy and help, when appropriate, to moderate inflation pressures. Price support measures for energy consumers decrease inflation in the short run and may thus help anchor inflation expectations, but their necessary withdrawal after a limited time span could rekindle price pressures. In countries where inflation is particularly high and there are signs of excess demand, such as the Baltic countries or Central and Eastern European economies, a tighter fiscal stance should play a role in countering demand pressures, especially in the absence of an autonomous monetary policy. Given that those countries are often welcoming large numbers of Ukrainian refugees and, in some cases, plan to increase defence spending soon, tighter fiscal policy calls for expenditure restraint elsewhere or for higher taxes.

Over the medium and long term, the conflict in Ukraine is raising new fiscal priorities and thus reinforcing the need to change the composition of the public finances. In Europe, many countries are planning to increase expenditure on defence. Higher spending targets have often been set for well beyond the end of the projection horizon, but in a few countries, such as Germany and Poland, a large increase (in the range of 0.5 to 1% of GDP per year) has been announced already for 2022-23. In addition, the goal of reducing reliance on fossil fuel supplies from Russia has lent new urgency to investments in clean energy and energy efficiency, whose budgetary costs go clearly beyond NGEU grants (OECD, 2021a).25 As an alternative to increasing tax burdens, countries will need to revisit the allocation of public spending across budget items and functional areas, and seek to reduce outlays which tend to be detrimental to growth, such as subsidies, while ensuring compensating measures to prevent adverse impacts on inequality. Achieving efficiency gains in spending should also be a priority, which for both defence and clean energy spending may require coordination across countries, be it within military alliances and procurement programmes, or as regards grid and recharging infrastructure.

Beyond 2023, rising debt service burdens are also likely to compound challenges for the public finances. After declining for several years, implicit interest rates on public debt are now levelling out over the projection horizon, as ongoing and expected monetary policy normalisation pushes up long-term interest rates (Figure 1.45). The eventual upward pressure on debt service burdens in the medium term will ultimately be heightened by elevated public debt levels (Rawdanowicz et al., 2021). Credible fiscal frameworks with strong national ownership can provide clear guidance to citizens and markets about the medium-term trajectory of the public finances and help implement reforms to public expenditure.

Figure 1.45. The implicit interest rate on public debt is bottoming out

Interest rates and public debt in the median OECD advanced economy

Note: The implicit interest rate is defined as general government interest payments divided by general government gross financial liabilities at the end of the preceding year.

Source: OECD Economic Outlook 111 database; and OECD calculations.

 StatLink https://stat.link/kecy21

Emerging-market economies have limited scope for additional policy support

Persistent inflation pressures in many emerging-market economies, where food has a large weight in spending and consumer prices (Figure 1.46), and the ongoing policy normalisation in advanced economies have led to multiple policy rate increases in recent months despite continued economic slack. These factors will likely prompt further monetary policy tightening in the remainder of 2022. In 2023, rate increases are projected in some emerging-market economies, with policy rates remaining at high levels in many others. Inflation expectations in many emerging-market economies are often more sensitive to inflation shocks, and thus less well-anchored, than in advanced economies (Ha et al., 2022). Given the large potential impact of food and energy price increases on wage demands and inflation expectations, central banks in emerging-market economies have tightened policy in response to surging headline inflation, even if core inflation developments have been more moderate. Additional monetary policy tightening should be accompanied by clear communication and careful adjustment of the pace of the tightening to re-anchor inflation expectations. Countries with low public debt-to-GDP ratios should ensure that the pace of policy tightening is strong enough and frontloaded to contain inflation expectations, with rising interest rates less likely to put public debt sustainability at risk.

Figure 1.46. Food and energy shares in consumption are large in emerging-market economies

Weight in the CPI

Note: CPI weights follow the 2018 COICOP classification for Costa Rica and the 1999 COICOP classification for the remaining countries. Data as of 2017 for Russia, and as of 2021 for the remaining countries. “Advanced OECD” refers to an unweighted average across OECD member countries, excluding Chile, Colombia, Costa Rica, Mexico and Türkiye.

Source: OECD Database on Consumer Price Indices.

 StatLink https://stat.link/qro0gc

The pace and extent of policy rate increases is expected to continue to vary widely across major emerging-market economies. In Latin America, policy tightening has been frontloaded, given the inflationary effects of supply-chain disruptions in Mexico, the need to strengthen the macroeconomic policy framework and offset very high inflation in Argentina, and inflationary pressures in Brazil stemming from an acceleration in energy and food price increases. In India, after an initial rise in May 2022, policy rates are projected to increase further amid persisting inflationary pressures. In contrast, monetary policy tightening in Indonesia is projected to be only limited, helped by milder inflation pressures. Reductions in reserve requirement ratios and benchmark interest rates have recently taken place in China to address the slowdown in growth, but no additional monetary policy easing is projected. In Türkiye, policy rates are projected to stay unchanged given the authorities’ commitment to an accommodative monetary policy stance, even though negative real policy rates could increase currency volatility and add to inflationary pressures.

The scope for additional fiscal support to protect vulnerable consumers from more expensive food and energy is limited in many emerging-market economies, with fiscal deficits often still considerably above their pre-pandemic levels (Figure 1.40, Panel B). Rising financing costs also decrease the room for manoeuvre in commodity-importing countries. For instance, sizeable social transfers and VAT reductions introduced to offset the effects of rising commodity prices may put fiscal sustainability at risk in Türkiye.26

Commodity-exporting countries, whose budgets often benefit from higher commodity prices, need to strike a balance between restoring sound public finances and using windfall revenues to complete the recovery from the pandemic and support vulnerable citizens. For example, in South Africa, financing the prolongation of social programmes created during the pandemic with the surge in fiscal revenues is projected to support household incomes while preserving debt sustainability. In contrast, fiscal policy is projected to be expansionary in Brazil, with spending pressures from forthcoming presidential elections going beyond windfall revenues.

Enhancing energy security via new sources of supply and a stronger push to low-carbon sources

The current crisis has highlighted the issue of energy security in the longer term, with many OECD countries still heavily reliant on fossil fuel energy and supply from Russia, as well as the need to hasten the transition to net zero emissions by 2050 (IEA, 2021a). Energy security concerns many aspects: energy system disruptions (extreme weather conditions or accidents), short-term balancing of demand and supply in electricity markets, regulatory failures and the reliability of supply from producers of fossil fuel resources. Energy systems have also become more interconnected across the world. This brings new opportunities but also challenges.

There is an inextricable link between energy security and climate change, as energy represents between half and two-thirds of total greenhouse gas emissions. The efforts needed to carry through on the pledge to net-zero emissions by 2050 are important (IEA, 2021b), notably to address future emissions of existing energy-related infrastructure – power and industrial plants, buildings and vehicles. In the longer term, OECD countries should reduce their overall reliance on fossil fuel imports by providing appropriate incentives to move away from fossil fuels and investing significantly in clean energy and energy efficiency. In Europe, improving the interconnection among domestic electricity grids can reduce energy costs and improve security. Improved storage capacity and diversification of energy sources will be necessary to limit volatility in oil and gas markets during the energy transition.27

There is no single policy mix to successfully achieve decarbonisation, given differences across countries in industrial structure, preferences and fiscal constraints. A mix of policy actions including effective carbon pricing, changes in standards and regulation, and structural reforms will be needed to reduce emissions at a minimum cost and facilitate the reallocation of resources towards low-carbon activities (D’Arcangelo et al., 2022). More generally, a strategic clean energy transition should aim to reduce vulnerabilities along the way, and be coupled with investment in innovation to develop the technologies needed for net-zero. Public acceptance of such policies will also be vital, as many poorer households face hard consumer choices when prices surge. Steps to improve funding for green infrastructure and low-carbon policies would help to improve public acceptance, together with appropriate redistributive policies that provide help to the most affected households.

Restructuring global-value chains could have costs

The COVID-19 crisis has put global value chains (GVCs) under high pressure and the war in Ukraine is adding further stress, testing the resilience of a production model grounded on international fragmentation and just-in-time logistics. This raises questions about a possible reconfiguration of supply chains, and the use of suppliers at less distant locations in order to shift the balance between the security of supply and efficiency considerations. Global value chains can be an effective means of expanding supply quickly when needed, as seen during the pandemic with the production of vaccines and personal protection equipment. At the same time, global production sometimes relies on critical raw materials or components sourced from just a few countries – an arrangement that can quickly become a vulnerability if geopolitical tensions rise and key suppliers are based in countries that have very different geopolitical priorities.

Improving security by adjusting the configuration of GVCs could reverse some of the efficiency gains from globalisation. Specialisation and economies of scale have brought productivity gains as well as lower production prices (Andrews et al, 2018; Pain et al., 2008). Such gains could dissipate if production is moved to more secure but costlier locations. Model simulations (Arriola et al., 2020; IMF, 2022b) show that less diversified supply chains and greater economic fragmentation would harm efficiency and economic stability when shocks are primarily domestic rather than global.

Governments still need to ensure that trade operates as efficiently as possible within supply chains, wherever they are located. Investment policies to modernise digital and physical infrastructures would improve trade logistics and reduce bottlenecks along production chains. Enhanced regulatory flexibility can facilitate innovation and supply diversification, and support resilience. More broadly, reducing unnecessary heterogeneity of technical standards that underlie regulations and non-tariff measures can facilitate easier substitution between alternative suppliers and help in cushioning shocks (Arriola et al., 2020).

Financial sanctions could lead to the development of alternative payment systems

The US dollar remains the dominant currency used in international trade, financial markets and in official foreign exchange reserve holdings (OECD, 2018; Bertaut et al., 2021). However, the financial sanctions now placed on Russia by the major advanced economies, which come on top of earlier sanctions imposed on Iran and Russia in 2014, raise the risk of greater fragmentation over time in cross-border payments and payment systems. In the short term, the exclusion of many Russian banks from the SWIFT payment messaging system will make financial transactions slower and more expensive for Russian institutions, and ultimately for their customers (firms and households). Although banks affected by sanctions can still request other banks to settle in US dollars on their behalf, doing so would significantly reduce the efficiency of cross-border payments (Berner et al., 2022). Banks may also be reluctant to undertake such transactions if there are risks of US secondary sanctions on banks in third countries undertaking dollar transactions.

In this context, an acceleration of the existing separate efforts by Russia and China to develop alternative payment systems is to be expected, especially for renminbi-denominated transactions.28 To date, these systems do not have the same global reach as SWIFT. Nonetheless, their development could diminish the efficiency gains from having a single global system, and potentially reduce the dominant role of the US dollar in financial markets and cross-border payments (Arslanalp et al., 2022). However, important technical and political constraints remain. Although China’s Cross-border Interbank Payment System (CIPS) can settle and clear cross-border payments, unlike SWIFT, it does so only for renminbi-denominated transactions.29At present the renminbi accounts for only a small share of global transactions, and less than 4% of official foreign exchange holdings, although its use is growing due to China’s greater size and rising importance in global trade. However, the current scope and size of CIPS is not sufficient to replace Russia's lost access to the international financial system and incentives to hold renminbi in official reserves are limited by the lack of full convertibility.