Inflation, War, Covid: The Federal Reserve Could Be Raising Interest Rates At a Complicated Time

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The Federal Reserve begins a key meeting today as war and coronavirus create an increasingly complicated economic environment.

Markets widely expect the Fed to raise its target interest rate by 25 basis points at 2 p.m. ET tomorrow. It would be not only the first increase since December 2018, but also potentially the first in a series of 6-8 hikes over the course of 2022.

Policymakers have carefully guided investors toward the idea of rate hikes since late 2021. One goal was to normalize interest rates after slashing them near zero during the pandemic. The other objective is to slow accelerating inflation as economies reopened amid widespread shortages.

Russia’s invasion of Ukraine on February 24 has made things a lot more complicated by creating a historic squeeze in commodity prices. Oil spiked to its highest level since 2008. Agricultural products like wheat and corn jumped to new highs. (Russia and Ukraine are both major farming nations and fertilizer producers.) Metals like aluminum, iron ore and nickel surged because of disruptions resulting from the war.

10-year Treasury Yield Index ($TNX.X), weekly chart.

The post-invasion surge will probably increase inflationary pressures in coming months. However it creates a completely different risk for Chairman Jerome Powell and his team to navigate: weakening confidence.

Recession Risk?

Most economic data was pointing toward a strong recovery before the conflict. Employment was surging as pandemic-hit industries like hospitality rehired workers. Factories struggled to keep up with orders. But now conditions are weakening.

Inflation is the first culprit. Last week, spiking gasoline prices pushed the University of Michigan’s consumer sentiment index to its lowest level in over a decade. Goldman Sachs lowered its 2022 growth forecast and saw greater risk of a recession. Other signals, like the flattening yield curve and rising junk-bond spreads may paint a similar picture.

Another risk emerged this week as China reimposed coronavirus restrictions in the manufacturing hub of Shenzen. The move impacted Foxconn, a key supplier for Apple (AAPL), and could have wider impacts across global supply chains.

CME’s FedWatch tool showing forecast interest rate in December. Notice rising expectations in the last month.

Rising prices and slower growth could result in “stagflation”: a stagnating economy combined with inflation. It could be a difficult environment that the Fed hasn’t really faced since the early 1980s. Its solution under Chairman Paul Volker was to cause a recession, which killed inflation.

What Will the Fed Do?

While that might sound scary, it’s important to realize that the Fed is nowhere near the situation 40 years ago. That period followed an entire decade of steadily rising inflation, with various unsuccessful attempts to solve the problem. For example, President Richard Nixon imposed price controls in 1970 and fuel rationing in 1973. Gerald Ford followed with the ridiculous WIN (“whip inflation now”) program one year later.

The current inflationary trend is only about one year old, with a handful of clear causes. First was the pandemic, which slowed production of key products like cars, semiconductors and lumber. Second was government policy as Congress and the Fed injected trillions of dollars into the economy. Third was the spike in commodity prices, recently aggravated by the Ukraine crisis.

The potentially good news is that all three of these conditions may change. More people returning to work will increase production and may help ease price pressures. Lawmakers and the Fed are reducing stimulus. Finally, oil prices are notoriously volatile and only a few years ago faced a supply glut. A few improvements in the geopolitical situation and a few more months of rising energy production could make a big difference.

Powell could respond by acknowledging that risks have increased, but not enough yet to change policy yet. As terrible as the military situation is, investors are still hoping it will pass. Policymakers at the Fed could take a similar approach — at least for now.

So, in addition to raising by 25 basis points, central bankers may increase the number of expected hikes in 2022. (The so-called “dot plot” in December’s Summary of Economic Projections predicted three hikes.) They could also change the outlooks for inflation and long-term economic growth.

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