Will the Ukraine war impact the Fed rate hike plans?

Even as the Ukrainian crisis deepens and the price of Crude crosses $100/bbl, back in the US, senior Fed officials are apparently working furiously on their calculators. The big question is how the unfolding conflict in Ukraine might influence the American economy and their planned shift to tighter monetary policy. For now the room is divided with experts on both sides of rate policy, but this is the big question for the Fed to answer.

Check - Why is crude beyond $100/bbl and what does it really mean

There is a strong reason. Oil and commodity price shocks could be a setback to global growth engine and consumer confidence. That is already evident. Analysts are already cautioning that the Ukraine story could dampen the Fed enthusiasm to raise rates in the March policy. Another perspective is that March rate hike may still happen, but the Fed may tread more cautiously after that and prefer to gauge the impact of its decisions.

Even FOMC members are now admitting that the unfolding situation in Ukraine could seriously impact the medium-run economic outlook in the US and would most likely also be a consideration in determining the pace of rate hikes. The enthusiasts like Goldman Sachs were counting on 7 rate hikes in year 2022, but that may not be exactly feasible if the global situation remains fluid. The invasion, to that extent, has been surely an unsettling event.

Now FED sees risks to getting too hawkish. For instance, high oil prices could weigh on consumer spending and could spike inflation even further. Also, it is not yet clear how Russia will react to sanctions by the West. For now, the underlying demand is strong, but if crude crosses $110/bbl, then equations could change drastically. That is what is forcing the FED to serious rethink if aggressive series of rate hikes would really be feasible in 2022.

On 24 February, the oil prices spiked all the way to $105/bbl, albeit briefly. This is the highest level for oil since 2014. In fact, the CME Fedwatch was indicating that the probability of a 50 bps rate hike in March 2022 had fallen overnight from 33% to 10%. FED sees the urgent need to hike rates to tame inflation at around 7.5% and one of the most robust economies in recent times. However, timing has come into question post the Russian crisis. 

In a new thinking at the FED, they are now highlighting the stagflation risk in the US, which is a period of high inflation and weak growth. That is what the US does not want. They have seen that during the oil crisis of the 1970s and don’t want that to repeat. Only the theatre of the battle has shifted from the Middle East in the 1970s to Russia in 2022. Back then, the US had seen one of the worst bouts of stagflation with rising inflation and falling growth.

One thing is now clear that FED officials may tread more carefully until the true import of Russia's actions, and the impact on oil prices is fully known. The US sees a tipping point where confidence could get affected. FED remains confident that tightening plans will not be derailed, but such confidence means nothing in the face of a global show-stopper. FED, for now, is confident that the real risk may be for Europe and not for the US.

Playing the devil’s advocate in this context, one can say that sizeable disruptions to supply chains and energy prices could get complicated and deepened by the war. Also, if EU slows and the ECB is not too keen to tighten, then it leads to monetary divergence risk. The FED and the US may be all set to hike the rates as planned. However, there is now a strong possibility that the March 2022 hike would be just 25 bps instead of 50 bps.