The U.S. Fed’s pivot away from the view that inflation is “transitory” signaled the beginning of the end for the ultra-low rate environment we have come to think of as normal.
Past inflationary cycles rarely end well for financial markets.
Such ramifications are still being assessed in financial markets, particularly on the outlook for the policy response.
Klaus Vedfelt/DigitalVision via Getty Images The U.S. Federal Reserve’s (“Fed”) pivot away from the view that inflation is “transitory” signaled the beginning of the end for the ultra-low rate environment we have come to think of as normal.
Financial markets reacted to this new information by aggressively repricing shorter-term interest rates to start the year. The exit from these policies now appear well priced-in for the U.S. as yield curves have flattened to levels typically associated with the end of a tightening cycle. Investors are now debating the terminal rate and what happens if inflation does not fall as much as consensus and the Fed expects.
It looks almost certain that the Fed must end the era of quantitative easing (“QE”). Was QE a success? We must wait for quantitative tightening (“QT”) to see. The ultimate judge of more than a decade-long experiment in unconventional policies lies in how the Fed can balance its conflicting objectives of maximum employment and stable prices without fully knowing how financial conditions will respond.
Past inflationary cycles rarely end well for financial markets. The Russian invasion induced spike in commodity prices holds the potential to further exacerbate what might already be in train: a wage-price spiral. The risks surrounding this scenario have clearly increased and a more cautious outlook for this downside possibility is increasingly warranted. A stagflationary shock
The economic and financial impact of the Russian invasion of Ukraine represents a stagflationary shock for the global economy. The prices of commodities, including fuel, food and metals are all surging. Stagflation, an economic environment of stagnant growth and rising inflation, was once a long-tail risk, but now appears to be a real possibility.
Figure 1 highlights crude oil and European natural gas prices have spiked to multi-year highs in a matter of days. As the Russian-Ukraine conflict continues, higher energy and commodity prices may feed through to broader increases in inflation and-combined with negative sentiment and confidence-a decline in global growth. So far, estimates for those impacts remain modest but hinge critically on the severity of the energy price spike, its duration, and the potential secondary effects.
Figure 1: Russian invasion is creating shocks in energy markets
Brent crude oil and European natural gas futures prices Bloomberg, as of 3/8/22. Markets typically price geopolitical risks quickly. However, with no clear near-term off-ramp for the conflict, we may be at the beginning of a more permanent reordering of Russia’s role in the global economy and more uncertainty as the West counteracts these rising tensions.
Such ramifications are still being assessed in financial markets, particularly on the outlook for the policy response. For Europe, with a more direct hit to both inflation and growth, dramatic shifts in security and energy policy suggest an accommodative fiscal policy response while the European Central Bank (“ECB”) outlook has become more balanced between the inflationary (tighter) and growth (loosening) impacts.
For the U.S., higher commodity prices may flow into a longer period of elevated inflation, further bringing into question the forecast for its rapid decline in the second half of 2022.
That will keep pressure on the Fed to normalize its currently highly accommodative stance. Flight-to-quality assets, a popular safe haven during periods of rising geopolitical tensions, may be a less sure outcome given the backdrop of tightening monetary policy. Expect more shockwaves
The unprecedented level of sanctions imposed on Russia is tantamount to completely removing the country from the global economy. Government officials and Russian-owned companies have been targeted. Its banking sector has been removed from the SWIFT messaging system-essentially disconnecting it from the financial system. Its capital markets have been cut out of global indices. Foreign private companies have stopped selling products and services in Russia. Even yachts have been seized.
The latest move by the U.S. to ban its imports of Russian oil sent oil prices even higher. Extending this ban into Europe particularly in the short run and for Russian gas may not initially be possible, given the current dependency of Europe on Russian gas. However, the realization of the vulnerability has sent European energy and security policy on a new course with significant longer-term consequences. The magnitude of the energy price shock […]