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Ukraine war unlikely to deflect Fed from path of interest rate rises

Russia’s invasion of Ukraine has injected new uncertainty into the economic outlook but is unlikely to derail the Federal Reserve’s plans to begin raising interest rates from March, as it seeks to combat the highest inflation in 40 years.

Episodes of acute geopolitical tension have in the past prompted the US central bank to postpone making major policy decisions to avoid adding more volatility to a tumultuous situation.

But one of the tightest labor markets in decades and fears that the conflict will worsen inflation is likely to motivate the Fed to plow ahead in roughly two weeks with the first interest rate increase since 2018.

Still, the first rate rise is only expected to be a quarter of a percentage point as opposed to a supersized half-point increase as some have speculated, given concerns about how Russia’s assault on Ukraine could temper economic growth, and earlier resistance from many Fed officials.

Financial volatility stemming from new sanctions against Russia’s central bank, which aims to isolate Moscow from the global financial system and strip it of its ability to defend its currency, is likely to further dampen the appeal of an aggressive move.

“The injection of additional uncertainty in the environment will cool the ardor for rapid adjustment, but will not inhibit them from making the first several steps down the road of policy adjustment,” said David Wilcox, who used to lead the research and statistics division at the Federal Reserve.

But he added that the enormous unpredictability of geopolitical tensions alongside updated US employment and consumer prices data ahead of the Fed’s March gathering will give officials a lot of new information to parse.

The expected March tightening will mark the start of a series of rate rises aimed at curbing the robust demand that has contributed to inflationary pressures.

The Fed typically raises interest rates in quarter-point intervals and has not delivered a half-point adjustment since May 2000.

“It does not look like the situation in Ukraine, as horrible as it is, changes the basic fact that the Federal Reserve is facing, which is that monetary policy is very far from neutral,” said Andrew Levin, who worked at the central bank’s board for two decades and now teaches at Dartmouth College, referring to the level of interest rates that is neither accommodative nor restrictive.

“The Federal Reserve needs a clear plan and needs to explain that plan to Congress, to the markets and to the public how it is going to make sure it carries out its commitment to price stability,” said Levin, who supports the central bank opting for a jumbo, half-point rate rise in March, “barring some unthinkable geopolitical event”.

Fed chair Jay Powell will get that opportunity this week as he heads to Capitol Hill to testify before the House of Representatives on Wednesday and the Senate on Thursday.

Powell is likely to be grilled on the economic implications of Russia’s full invasion of Ukraine, which has sent Brent crude soaring past $ 100 a barrel for the first time since 2014 when Russia annexed Crimea. He will also face questions about how aggressively the central bank will need to tighten monetary policy in response, and how they will factor in any related market turmoil.

One fear is that starting with a half-point increase could muddle the Fed’s messaging and upend market expectations about the path of interest rates – which Lael Brainard, a governor who was tapped by President Joe Biden to serve as the central bank’s vice-chair, recently acknowledged are “clearly aligned” with the outlook for a “series” of rate increases starting in March.

“A quick shift in monetary policy is when the mistakes come,” warned Priya Misra, head of US rates strategy at TD Securities.

Traders are still pricing at roughly six quarter-point rate rises this year, which will bring the federal funds rate to 1.5 per cent. More are expected in 2023.

Expectations were adjusted after Powell last month refused to rule out either half-point rate rises this year or interest rate increases at each of the remaining seven policy meetings.

Wilcox, who is now affiliated with the Peterson Institute for International Economics and Bloomberg Economics, added that by starting at a more gradual pace in March, the Fed gives itself flexibility.

“They will buy time during that period during which they can gather additional evidence about how persistent the additional inflation shock is, if there is yet another impulse to inflation coming from a substantial spike in oil prices or other unforeseen aspects of the Ukraine situation [and] how quickly are supply chains otherwise rectifying, ”he said.

“All of that will inform their decision down the road about how far and how quickly they need to go in raising the funds rate.”

Investors will gain even more clarity about the possible path forward next month when the Fed releases an updated dot plot of the interest rate projections of individual officials. In December, the last time it was published, a majority of policymakers expected to deliver just three quarter-point rate rises this year. Three months prior to that, they were split on even one 2022 rate rise.

March’s version will again be overhauled, showing at least four interest rate increases this year and potentially the need for action at every meeting from then.

There are concerns about the Fed moving too gradually, however.

In a recent poll conducted by the Financial Times and the Initiative on Global Markets at the University of Chicago Booth School of Business showed, however, nearly half of the economists surveyed said the Fed will fail to control inflation if it delivers only six quarter-points rate rises this year as markets expect.

Of the 45 respondents, 40 per cent believe the federal funds rate will need to be at or above 2 per cent this year in order for the central bank to achieve both stable prices and maximum employment.

Half of that segment said it should exceed 2.5 per cent.

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