## Navigating Fragmentation, Conflict, and Large Shocks

_IMF News, June 21, 2024_

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**Canonical URL:** [Navigating Fragmentation, Conflict, and Large Shocks](https://www.imf.org/en/news/articles/2024/06/21/sp062124-fdmd-nbu-nbp-annual-research-conference)

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## Bibliographic details
- Published: June 21, 2024

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### Introduction
- Focus: impacts of Russia’s invasion of Ukraine on Ukraine, neighboring countries, and the global economy; implications for monetary policy in a more shock-prone environment.
- Key judgments:
  - The war is now in its third year.
  - The war has increased fragmentation pressures and raised defense spending.
  - Compared with decades of efficiency-driven economic integration, recent measures will likely make the global economy more shock-prone with higher inflationary pressures, reduced potential output growth, and precarious public finances.
- Policy questions posed:
  - How should central banks conduct monetary policy in this more shock-prone environment?
  - What is the role of additional tools such as foreign exchange intervention?
  - How should fiscal, financial, and structural policies be deployed to support macroeconomic and financial stability?

### Effects of war on Ukraine
- Macroeconomic outcomes and policy responses:
  - Strong global support and policies, including actions by the National Bank of Ukraine, helped Ukraine avoid deep macroeconomic instability and "kept inflation from spiraling."
  - Output is roughly 25 percent below its pre-war level.
  - Much of the capital stock has been destroyed by war.
  - Ongoing help is needed; the Ukraine Recovery Conference in Berlin (June 11-12) discussed global assistance.
- Recent policy moves noted:
  - Emergency monetary and FX policies: raising interest rates, fixing the hryvnia to the dollar, introducing FX and capital controls.
  - Use of some monetary financing to finance the war; negotiated official and private debt standstills; rationalized discretionary public expenditures.
  - Later steps: monetary financing ceased; exchange rate peg replaced by a managed float; FX controls cautiously eased.
  - Multiyear financing arrangement with the IMF anchors macro policy; a 4-year 50-billion euro Ukraine Facility with the EU; large contributions from the US and other partners.

### Wider impact of the war
- Inflation:
  - The war has been a major supply shock, especially for CESEE and other European countries reliant on Russian natural gas.
  - When gas stopped, energy prices skyrocketed, boosting inflation; disruptions in Ukraine’s grain exports contributed to food inflation.
  - CESEE experienced the largest inflationary impact over the past two years (see Figure 2).
  - Higher cumulative inflation rates in CESEE have left them with a potential competitiveness problem.
- Growth:
  - The conflict has derailed recovery from the COVID-19 pandemic via adverse terms-of-trade effects and tighter monetary policy.
  - Trade has been hit, especially for CESEE countries with major trade links to Russia.
  - CESEE countries have experienced the biggest setbacks to growth performance since the onset of the war (see Figure 3).
- Defense spending and public finances:
  - Defense spending is likely on a permanently higher trajectory.
  - Effects particularly pronounced in the CESEE region, especially the Baltics (see Figure 4).
  - Higher defense spending compounds fiscal pressures from COVID-19, green transition, and demographics, requiring difficult steps to keep debt sustainable.

### Turning point for geoeconomic fragmentation
- Acceleration of fragmentation:
  - Russia’s invasion of Ukraine has been a catalytic turning point accelerating geoeconomic fragmentation away from efficiency-based global trade.
  - Number of new trade restrictions in each of the last two years has tripled relative to 2019 (see Figure 5).
- Trade and FDI realignment:
  - Trade has fallen much less between geopolitically aligned groups than between more divergent countries (see Figure 6); similar patterns for FDI.
  - Firms must now account for national-security constraints and geoeconomic uncertainties when structuring supply chains.
- Macroeconomic model-based scenarios and risks:
  - April 2023 WEO model-based analysis suggests fragmentation could reduce the level of output in a bloc centered around China by over 3 percent in the long run (left-hand panel of Figure 7).
  - Financial fragmentation scenario: real interest rates in a U.S.-centered bloc could increase due to waning flows of savings from surplus economies in a China-centered bloc; some decline in real interest rates in the China bloc as they invest more domestically (right-hand panel of Figure 7).
  - Fragmentation can weaken risk-sharing and diversify less, leading to more volatile capital flows (left-hand panel of Figure 8); effects especially pronounced for emerging markets (right-hand panel of Figure 8).
  - Simulations where trade in commodity groups is banned between blocs show large first-year inflation impacts for some commodities and blocs (Figure 9).
- Implication: a less integrated global economy will be poorer and more shock-prone, reinforcing the need for policy preparedness.

### Implications for monetary policy
- General implications:
  - A more fragmented global economy implies inflation will deviate from target by larger magnitudes and for more prolonged periods.
  - Supply-driven shock volatility complicates tradeoffs for central banks between stabilizing inflation and employment; employment expected to be more volatile around potential.
  - Protracted high inflation can change transmission: "intrinsic" persistence in the Phillips Curve may rise via indexation and dislodged inflation expectations; nonlinearities may become pronounced in high-pressure, high-inflation environments.
  - Resulting asymmetry: large shocks may produce substantial upward skewness in inflation responses.
- Policy rule considerations:
  - Forecast-based policy rules that set policy rates based on medium-term inflation forecasts have appeal but may perform poorly when uncertainties are large and asymmetric.
  - A risk-management strategy that accounts for tail risks is preferable to focusing heavily on a central forecast.
- Model illustration and lessons:
  - A New Keynesian model with nonlinear Phillips Curve and endogenous indexation shows:
    - Cost-push shocks have small/transient effects when inflation near steady state, but large/persistent effects if shocks are persistent and indexation rises.
    - Policymakers must estimate persistence (Kalman filter); reacting only to medium-term forecasts can delay response and allow inflation to surge (Figure 10).
    - Reacting to realized core inflation preempts inflation surges but at some output cost (orange lines in Figure 10).
  - Practical implication: central banks must balance underreacting to persistent shocks against overreacting to transient ones; more focus on nearer-term forecasts and realized inflation may be warranted, accepting some short-run output/employment costs.
  - Anchoring medium- and long-term inflation expectations remains important but does not guarantee appropriate risk balance.

### Responding to higher capital flow volatility
- Emerging market concerns:
  - Capital flow volatility and exchange rates likely to be more volatile in a conflict-prone environment.
  - The Fund’s Integrated Policy Framework (IPF) helps identify when FX intervention (FXI) and inflow capital flow management measures (CFMs) may improve policy tradeoffs for EM central banks.
- Guidance on FXI:
  - The bar for FXI should be set fairly high; flexible exchange rates desirable if FX markets are deep and financial stresses modest.
  - Stronger case for FXI if FX market depth is low and the economy faces external shocks with deteriorating investor sentiment and tighter financial conditions.
  - Central banks must consider intertemporal tradeoffs: supporting the exchange rate today may compromise future ability to provide FX liquidity, especially when reserves are limited and shocks may persist or intensify (a key risk in military conflicts).

### Need for supportive financial, fiscal, and structural policies
- Financial stability and resilience:
  - Monetary tightening required to contain inflation may fuel financial market stress and risk "financial dominance."
  - High premium on enhancing financial system resilience: deepen monitoring of financial risks, focus on the sovereign-bank nexus, nonbank risks, payments system risks (including cyber).
  - Ensure adequate prudential buffers; build capital where profits are strong.
  - Readiness for emergency liquidity assistance (ELA) and effective resolution strategies is essential.
- Fiscal policy:
  - Responsible fiscal policy is critical: expansionary fiscal stances increase pressure on monetary policy and can amplify financial vulnerabilities and fiscal dominance risks.
  - Given potential ratcheting up of defense spending and refugee support, governments should balance needs by paring spending elsewhere while protecting vulnerable populations.
- Structural reforms:
  - Structural reforms can strengthen potential output and shock resilience (Figure 11).
  - Larger, more economically integrated regions are less prone to shocks; deepening links with the EU is beneficial for non-EU European economies.
  - For the EU, moving closer to a true "single market" by lowering barriers to cross-border mobility in services, goods, and labor will add to strength and resilience.
  - Mobility on certain dimensions, especially labor, remains far below that in the United States.

### Closing remarks
- Early lessons from Ukraine’s response (preliminary assessment on four fronts):
  1. Macroeconomic stability aligned with national security: rapid, tough, innovative decisions preserved core state functions—pensions paid, bank branches open, tax ratios remained high.
  2. Agility and adaptability: monetary financing ceased; domestic bond market revitalized; domestic revenue mobilization and external debt restructuring underway; peg replaced by managed float; FX controls cautiously eased.
  3. Coordination while maintaining independence: coordinated monetary and fiscal policy was and remains essential for a shock of this magnitude.
  4. Resource mobilization and reforms: turned to external donors; multiyear IMF arrangement anchors macro policy; 4-year 50-billion euro EU Facility and large contributions from partners; sustained structural reforms to build institutions for post-war future.
- Conclusion:
  - Singular focus on maintaining macro stability with policy agility, ownership, sustained reforms, and external support has supported Ukraine through wartime challenges and sets the stage for a robust recovery toward EU accession.
  - Policymakers must prepare to navigate a more volatile world shaped by fragmentation and conflict—central banks, fiscal authorities, and structural reform agendas all have critical roles.

*Remarks by Gita Gopinath, IMF First Deputy Managing Director, at the NBU-NBP Annual Research Conference, June 21, 2024.*

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## References

- [Gita Gopinath](https://www.imf.org/en/about/senior-officials/bios/shirin-hamid)
- [Speeches](https://www.imf.org/en/news/searchnews)
- [PRESS CENTER](http://presscenter.imf.org/)
- [A quantitative microfounded model for the Integrated Policy Framework](https://www.imf.org/en/Publications/WP/Issues/2021/12/17/A-Quantitative-Microfounded-Model-for-the-Integrated-Policy-Framework-510977)
- [Second-round effects of oil price shocks – implications for Europe’s inflation outlook](https://www.imf.org/en/Publications/WP/Issues/2022/09/06/Second-Round-Effects-of-Oil-Price-Shocks-Implications-for-Europes-Inflation-Outlook-523201)
- [Integrated monetary and financial policies for small open economies](https://www.imf.org/en/Publications/WP/Issues/2023/08/04/Integrated-Monetary-and-Financial-Policies-for-Small-Open-Economies-537587)
- [An Integrated Policy Framework (IPF) diagram for international economics](https://www.imf.org/en/Publications/WP/Issues/2024/02/23/An-Integrated-Policy-Framework-IPF-Diagram-for-International-Economics-545125)
- [Is high debt constraining monetary policy? Evidence from inflation expectations](https://www.imf.org/en/Publications/WP/Issues/2023/06/30/Is-High-Debt-Constraining-Monetary-Policy-Evidence-from-Inflation-Expectations-534708)
- [Shocks and Capital Flows: Policy Responses in a Volatile World](https://www.elibrary.imf.org/display/book/9798400211263/9798400211263.xml)
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- [World Economic Outlook: A Rocky Recovery. April 2023](https://www.imf.org/en/Publications/WEO/Issues/2023/04/11/world-economic-outlook-april-2023)
- [Global Financial Stability Report: Safeguarding Financial Stability amid High Inflation and Geopolitical Risks. April 2023](https://www.imf.org/en/Publications/GFSR/Issues/2023/04/11/global-financial-stability-report-april-2023)
- [World Economic Outlook: Navigating Global Divergences. October 2023](https://www.imf.org/en/Publications/WEO/Issues/2023/10/10/world-economic-outlook-october-2023)
- [Integrated Policy Framework – Principles for the Use of Foreign Exchange Intervention](https://www.imf.org/en/Publications/Policy-Papers/Issues/2023/12/20/Integrated-Policy-Framework-Principles-for-the-Use-of-Foreign-Exchange-Intervention-542881)
- [https://www.imf.org/en/home](https://www.imf.org/en/home)

_Source: https://www.imf.org/en/news/articles/2024/06/21/sp062124-fdmd-nbu-nbp-annual-research-conference_