War in Ukraine and China Covid-19 lockdowns rattle markets, add to uncertainty.
Russia’s appalling invasion of Ukraine has profound geopolitical, humanitarian, and economic consequences. At the same time, new Covid-19 lockdowns in China adds fresh uncertainty on a global economic expansion already hamstrung by rising inflation and the end of fiscal and monetary stimulus. While our thoughts are with the brave Ukrainian people, this update focuses on the potential implications for inflation and the economy.
The highest inflation in 40 years was already a concern for Wall Street and Main Street alike before the invasion. A combination of record fiscal and monetary stimulus spurred record consumer demand for goods from Americans unable to spend during the pandemic. At the same time, the pandemic contributed to shortages of materials and labor and snarled supply chains, leading to shortages that added to the inflationary pressures.
Prices for groceries, gas, cars, and rent are all climbing rapidly. The Department of Labor reported that prices in February were 7.9% higher than a year ago, an acceleration from the previous month. Russia’s ongoing war with Ukraine could take inflation considerably higher, perhaps above 10%. The shunning of Russian petroleum has caused oil prices to jump to their highest levels since 2011. Last week they exceeded $130 a barrel for the first time since the financial crisis, reflecting concerns that the war-related supply shock could be lasting. New restrictions in China promptly pushed prices back below $100 a barrel, on fears of slower demand, a reminder that the pandemic isn’t over yet. Prices of corn and wheat, major exports of both Russia and Ukraine, have soared to their highest levels since 2008.
More inflation likely means slower growth. On the demand side, the bite of inflation will leave households with less money to spend. On the supply side, the already stretched supply chains will be further challenged by the repercussions of the war. Russia and Ukraine supply significant amounts of important materials for manufacturing, such as palladium (used in cars) and neon (production of semiconductors). New Omicron-driven lockdowns in Chinese manufacturing hubs are also set to exacerbate those supply imbalances. As we learned during the pandemic, an inability to source even one small part can hurt a company’s ability to make its products. By curtailing production, supply-chain problems inhibit growth and contribute to inflation. It’s safe to say that persistently high inflation is unlikely to abate in the near term.
The Federal Reserve is expected to raise their short-term Fed Funds policy rate today by 25 basis points from near zero, which would be the first increase since 2018. The small change will carry with it a major signal that the Fed has fully pivoted to inflation-fighting mode. The Fed is wrestling with how to signal the likely path of rate increases in the months to follow. Worsening inflation could cause them to accelerate the process, but they are trying to move carefully to avoid triggering a sharp correction in the financial markets.
The Federal Reserve’s main tool to combat inflation is by hiking interest rates, seen as a brake on the economy. When the Fed raises rates, this makes borrowing more expensive. Consumers and businesses are then discouraged from making investments, so this cools demand and brings prices back in control.
The Federal Reserve is trying to navigate an economy buffeted by dual headwinds of slowing growth and rising inflation, a combination that if left unchecked can become stagflation. The Fed now faces its most significant policy dilemma since our last bout of inflation 40 years ago. If it hikes too much and too rapidly, it risks slamming on the brakes of an already slowing economy, triggering a recession. If it hikes too slowly, it risks losing control not just of inflation but of inflation expectations. It’s the Fed’s responsibility to ensure these expectations remain anchored.
With growth slowing, a war in Europe and prices rising at the fastest pace in decades, the Fed has left itself with no good policy options anymore. The Fed has already erred in viewing inflation as transitory and stalling on decisions. It should acknowledge its policy mistakes and the need for a series of significant rate increases and a shrinking of their balance sheet, which doubled to $9 trillion during the past two years. As the old saying goes, “you can pay me now, or pay me later.” A little pain today could mean less pain tomorrow. The Fed has let the economy down easy before. But economists have warned that it could be a tough act to pull off this time around.
Financial markets have been under pressure throughout 2022, reflecting concerns about inflation, rising interest rates, and the shift in monetary policy. Expectations for tighter monetary policy has reduced appetite for some of the riskier assets that took flight in the pandemic’s easy-money environment. In recent weeks, markets have been roiled by fresh bouts of volatility due to the Russian invasion of Ukraine and new Covid-19 lockdowns in China. The uncertainty from all angles has clouded economic forecasts, with consensus estimates being revised lower for growth and higher for inflation. With conditions rapidly changing, these projections could shift again. We should expect elevated market volatility to persist for a while.
This information is for your general informational purposes only and should not be construed as investment advice or sole basis for making any recommendations. The views expressed are as of the date noted, and are subject to change. Past performance is no guarantee of future results.
Go back to our newsroom to read more stories.