As US and global energy companies stopped buying Russian oil, prices per barrel jumped to around $100, and gasoline and diesel prices hit record highs. Initially, it looked like it would only be a modest blow to the US economy. After all, the United States produces about as much oil as it consumes.
However, the economic damage was much greater. Indeed, rising oil prices have further fueled already raging inflation. It was a big problem before Russia invaded Ukraine, as the pandemic scrambled global supply chains, causing shortages of everything from vehicles to building materials. But the invasion of Russia created a much bigger problem. Double-digit consumer price inflation over the next few months is a real possibility. The rate for a 30-year fixed-rate mortgage loan has already jumped to nearly 5% from nearly 3% at the start of the year.
It’s too much for the Federal Reserve to tolerate, and policymakers are on high alert. Fed Chairman Jerome Powell and his colleagues have left no doubt in their forecasts and speeches: they plan to raise interest rates and they plan to do so aggressively.
The Fed will have to be cautious, however. In the past, when the economy struggled with high inflation and rising interest rates, recession invariably followed. The Fed finally pulls too hard on the proverbial monetary brakes to rein in inflation, stock prices plummet, housing markets crash, businesses stop investing and hiring, consumers cut spending, and the economy falters. It’s a delicate balancing act, to say the least.
To avoid a recession, it is essential that the Fed lower inflation expectations – what workers, businesses and investors think inflation will be in the future. Workers upset by the prospect of rising transportation, childcare and other living costs are demanding much larger wage increases, and companies are increasingly receptive. They think they can pass these higher labor costs on to customers by raising the prices of their goods and services. But it could create a dreaded wage-price spiral, where rising prices push wages up, and vice versa. The vicious cycle set in in the 1970s and early 1980s and forced the Fed of that era to raise interest rates and cause a deep recession.
There are different ways to measure inflation expectations, but the Fed should first focus on investors in inflation-protected Treasuries. Investors in these bonds bet their money on their mouth when it comes to forecasting inflation, and they currently believe that consumer price inflation will be well above 3% per year in the years to come. That’s way too high for the Fed’s comfort – it wants inflation to be below 2.5%, and preferably closer to 2%. It should therefore raise interest rates until it convinces investors that this is where inflation is heading.
Yet, like the Fed, it must be careful not to drive interest rates on short-term Treasuries higher than rates on long-term bonds. This so-called inversion of the yield curve does not happen often, but when it does, a recession eventually occurs a year or two later. In fact, for more than half a century, a recession has ensued whenever the two-year Treasury bill rate has consistently exceeded the 10-year Treasury bill rate. The yield curve is a prescient guesser, as short-term rates reflect what bond investors think the Fed will do in the near future, while long-term rates show what effect they think those Fed actions will have. finally on the economy. If investors think the Fed will raise rates too high too quickly and cause a recession, they will push short rates above long rates.
Two-year Treasury yields briefly rose above 10-year yields last month, signaling that recession risks are high, but the reversal was not long enough or significant enough to suggest a recession is imminent. . The Fed needs to set interest rates to make sure it stays that way.
But even if the Fed does this balancing act perfectly, it may not be enough. We will still need a bit of luck so that neither the pandemic nor the Russian invasion takes even darker turns. Considering everything we’ve been through over the past two years, we certainly owe it.