Energy Shock: A Russia-Ukraine conflict would make cost of living crisis worst on record

If Russia invades Ukraine, the resulting surge in energy prices could push inflation above 8%, cause the deepest fall in households’ real disposable incomes on record, and knock 1% off GDP in 2022. The Bank of England would probably respond to all this by tightening policy even further to prevent inflation expectations becoming unanchored.

Obviously, we don’t claim to have any special insight into how the geopolitical or military situation will pan out between Russia and Ukraine. The economic impact of any additional sanctions that follow or spill over into the corporate sector via asymmetrical warfare will need to be assessed later. Nevertheless, we can think through some of the possible economic consequences for the UK if the stand-off turns into a war.

Another supply side shock

The first point worth making is that there isn’t much non-energy trade between Russia and the UK, or Russia and the West in general. That means there is little scope for trade disruptions to dampen demand for UK exports. The UK exported only £4.1bn of goods and services to Russia in 2020 (0.7% of total exports).

However, Russia is a major exporter of commodities. As such, the main economic risk for the UK is that trade in major commodity markets is disrupted and prices rise. Indeed, even though the UK gets only around 3% of its natural gas from Russia, Europe’s energy market is heavily integrated.

Russia supplies a quarter of the EUs crude oil, and a fifth of its natural gas. There is no alternative producer with enough spare capacity to offset lower energy supplies from Russia, so disruption to Russian exports of oil and gas would send prices soaring across Europe and the rest of the world. From the UK’s point of view, this would be yet another shock to supply.

Our model

How high commodity prices could ultimately rise depends on a huge number of factors, such as how large any Russian invasion of Ukraine is, the extent of any damage to energy infrastructure, what sanctions Western countries impose on Russia and how President Putin responds.

Given the huge uncertainties around how commodity and financial markets might react, we have run a variety of scenarios through our model. It captures the dynamic impact of a potential shock in oil prices, natural gas prices, and market uncertainties on inflation, consumer confidence and GDP growth. The shock, however, is assumed to be a one-off, and models a swift military intervention instead of a long, full-scale war.

To provide context around that approach, a four-standard deviation increase in uncertainty is equivalent to the risk that afflicted UK financial markets during the global financial crisis.

How might a surge in energy prices and volatility in financial markets affect inflation, consumer confidence and GDP growth in the UK?

Inflation would surge

We modelled what impact a 10%, 20% and a 40% rise in energy prices might have on UK inflation. A 40% rise in the prices of natural gas and oil would probably result in inflation being around 1.6 percentage points (ppt) higher in Q2 than it otherwise would have been. A good general guideline is that a $10 increase in a barrel of oil increases inflation over the next year by about 0.15ppts.

We have assumed that prices fall back once tensions start to ease, but inflation would probably remain at least 1ppt higher than it otherwise would have been for the rest of the year. Given that we already expect inflation to reach a little above 7% in April, this could result in inflation peaking at between 8% and 9% in Q2 and still being above 4% in the first half of 2023.

Admittedly, households would be insulated from some of the rise in natural gas prices, and the associated rise in electricity prices, as Ofgem wouldn’t adjust the energy price cap until October. But another rise in energy prices in October would keep inflation higher for longer. And businesses would face the full force of the rise in price immediately.

What’s more, our model accounts only for movements in energy prices – the direct effects on inflation would also extend to food prices. Between them, Russia and Ukraine export a quarter of the world’s wheat, and Ukraine is a major corn exporter. This would put further upward pressure on food prices, which were already rising by 4% y/y in December.

All this would have the potential to turn the current cost of living crunch, which already threatens to be the deepest in a generation, into the biggest fall in spending power on record. The Bank of England recently warned that households’ real disposable income would fall by about 2% in 2022, and a Russian invasion of Ukraine could easily push this to a drop of between 3% and 4%.

To make matters worse, there is a chance that high energy prices feed higher inflation expectations and wage demands. In normal times, the Bank of England would ‘look through’ jumps in inflation caused by movements in energy prices. But the Bank has made clear that it is more concerned about inflation expectations getting out of control than it is about any damage to the macroeconomy from tighter monetary policy. As a result, the Bank may respond to a jump in energy prices by tightening monetary policy to head-off any rise in inflation expectations, rather than loosening policy to lessen the impact on household and business finances.

Impact of energy price shock on inflation in 2022

Consumer confidence would dip

We did a similar exercise to see how surges in the price of natural gas and oil would impact consumer confidence. As you would expect, the results show a clear negative effect on consumer confidence. Consumer confidence is closely related to consumer spending, so a drop in consumer confidence could lead to lower spending and slower GDP growth.

Impact of an energy price shock on consumer confidence

GDP would shrink

As well as higher oil and natural gas prices, it seems plausible that volatility in financial markets would spike as investors fled from risky assets. We incorporated this impact into our model. In our worst-case scenario of a 40% jump in oil and natural gas prices and a four standard deviation rise in uncertainty, GDP was about 0.6% lower in Q2 than it otherwise would be.

Our model suggests that, in our worst-case scenario, the economy could be about 1% smaller in 2022 than it would otherwise be.

Impact of energy price shock and higher volatility on GDP

A large part of the impact on GDP comes from the effect of higher oil prices on the economy. One way of thinking about oil prices in an economy like the UK’s, which is a large net importer of oil, is that higher oil prices effectively act like a tax on consumers and producers.

In 2019, the UK economy consumed £22bn worth of oil, when oil prices averaged $65 a barrel and, given that demand for oil is relatively inelastic, this would be unlikely to change in the short-term if the oil price were to rise. Accordingly, if the price of oil rose 40% from today’s price of $95pb to around $130pb and stayed there, the aggregate economy would have to spend an extra £22bn, or 1% of GDP, in order to consume the same amount of oil.

There is no magic number above which oil prices start to become a problem. Instead, a common rule of thumb is that a 10% increase in the price of oil reduces GDP growth by 0.1ppts.

However, there are a couple of reasons to think that the impact on the UK economy from an oil price shock could be smaller than previously thought. First, the UK has dramatically reduced its oil intensity. The amount of oil used to produce a unit of GDP has fallen by almost half since 2000, and by about 75% since 1965. This makes the economy much less sensitive to movements in oil prices.

Second, household balance sheets are much stronger than they were before the pandemic. In aggregate, households are sitting on excess savings worth about £225bn (10% of GDP) and consumer credit is £25bn lower than it was before the pandemic. This means that households can leverage their balance sheets to absorb some of the pain of rising inflation and higher oil prices. There is already some evidence that they are doing this; saving fell and borrowing increased in December, despite real GDP falling.


Our current forecasts of a 4.5% rise in GDP and average inflation of 5.5% in 2022 assume that the situation in Ukraine eventually calms down. How these forecasts change depends entirely on how the situation evolves, but it is entirely plausible that GDP growth could be closer to 3.5% and inflation above 6%.

That would represent a much tougher environment for middle market businesses, especially if the Bank of England presses ahead with tighter monetary policy.