Russia’s foray into Ukraine could cloud Federal Reserve rate moves

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Federal Reserve Chairman Jerome Powell testifies before a Senate Banking Committee hearing on oversight of the CARES Act in the Senate on Tuesday, November 30, 2021 in Washington, DC.

Kent Nishimura | Los Angeles Times | Getty Images

The outlook for a Federal Reserve rate hike after March may become less clear if Russia continues its foray into Ukraine.

That’s because the tensions have driven up the price of oil and gasoline, a major purchase for many Americans, and it’s the American consumer that generates about 70% of the US economy.

Prices for oil and other commodities rose on fears that Russian troop movements in Ukraine and sanctions by the United States and its allies could potentially lead to tight supplies. Russia is a major exporter of oil and natural gas. The country is also largest wheat exporter and palladium. Moscow is also a major player in nickel, aluminum and other metals.

“It’s really about oil rather than the other, wheat, palladium and nickel,” said Mark Zandi, chief economist at Moody’s Analytics. “Oil is probably up $10 or $15 a barrel because of the conflict… It will probably add, if it holds, about 30 or 40 cents a gallon to unleaded. That’s as much as a half -percentage point year-over-year consumer inflation, and we’re already at 7.5% I feel like that really complicates the Fed’s efforts to get inflation under control and return to full employment.”

Higher energy prices

Consumers across the United States paid an average of $3.53 per gallon for unleaded gasoline on Tuesday, up 90 cents from a year ago and 21 cents from last month, according to AAA. Crude oil is up about 50% over the past year.

Economists said it would be the price of oil that could ultimately determine Fed policy. Soaring oil prices are primarily a catalyst for inflation, and could eventually become disinflationary if the price rises and persists, dampening economic growth. Indeed, if Russia launches a full-scale military invasion of Ukraine, prices could rise much more, energy analysts say.

“It makes things more complicated,” said Bruce Kasman, JPMorgan’s chief economist. “There is a scenario where growth starts to be more important. There are also scenarios where price increases are not as detrimental to growth and fuel inflation.”

Kasman expects the Fed to make a quarter-point hike in the federal funds rate in March, with the situation in Ukraine weakening the case for a half-point hike. He plans six more rate hikes over the rest of the year.

This is where the outlook gets muddy for the central bank: On the one hand, a fear of growth could slow the pace of the hike. On the other hand, according to economists, the Fed could become even more aggressive if it sees a stronger pick-up in inflation.

“I certainly think oil is now about 30% above its fourth-quarter average,” Kasman said. “If you’re heading for a 75% increase, 100%, which would go from $120 to $150 [per barrel]so I have to believe there is enough damage here to negatively impact global growth.”

Zandi said the Fed is currently focused on getting inflation under control, which is much hotter and longer lasting than it had anticipated. He described a jump in oil prices to $150 as less likely and indicative of a “dark scenario”, but rising fuel prices could still attract Fed attention.

“I think it now reinforces their instinct to quickly normalize policy because they are more focused on inflationary effects than growth effects,” Zandi said. “The pandemic has been an additional supply shock and has been superimposed on another oil price shock. We have two severe supply shocks hitting at the same time. That is why it is so difficult for the fed.”

A rate hike is still to come in March

Kasman said the Fed would not be deterred from starting its rate hike cycle in March because it believes it is behind the curve. “Where we are in three or four months is really going to be a question of whether we see prices continue and its impact on growth,” he said. He expects average gross domestic product growth of 3.6% this year.

Kasman also points out that the Fed is not used to raising rates during a period when oil prices are rising.

“It certainly adds pressure. As long as growth is unaffected, rising inflation itself becomes a more medium-term issue,” he said. “On the other side of the coin, the fact that the Fed is tightening and we are getting a negative supply shock, that amplifies the impact of the negative supply shock on growth as the Fed is tightening. We haven’t seen this essentially since Paul Volcker.”

The former Fed Chairman was famous for his aggressive fight against inflation, raising the target federal funds rate to a high of 20% in 1981. Conversely, the Fed under President Jerome Powell is on the to raise interest rates from a current range of zero to 0.25. %.

“From the perspective of the Fed’s reaction function, Greenspan, Bernanke, Yellen, when they saw oil prices rise sharply, either it happened after they finished tightening or it prevented them from tightening up,” Kasman said.

Zandi said energy products accounted for 4.3% of consumer spending. Automotive fuel accounted for 2.7% of consumer spending in December 2021.

Consumer energy expenditure peaked at nearly 10% during the Volcker era in June 1981. The all-time low was reached in November 2020, when energy expenditure fell to 3.3%.

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