The Fog of War: Ukraine, Unity & Risks of Stagflation

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Russia’s invasion of Ukraine has done what the pandemic failed to do: It has unified much of the world against a common foe, Vladimir Putin. His unprovoked aggression toward Ukraine is acting as a cautionary tale against autocrats elsewhere, including China.

The sanctions on Russia are farther reaching and more punitive than in the past. The most dramatic move was the ban on transactions with Russia’s central bank. That stopped Russia from accessing billions in foreign exchange reserves that Putin had amassed to fund his war effort.

The ruble plummeted 30% in value the day sanctions were enacted. That forced Russia’s central bank to raise short-term interest rates to an unprecedented 20% to defend the exchange value of their currency and stem inflation. It will fail on both fronts, with Russia’s overly indebted households paying the price of Putin’s invasion.

Multinational companies are pulling back, cutting ties with state-owned companies and abandoning business in Russia. This is further isolating Russia while hitting its already fragile economy.

Western sanctions on Russian energy exports are being discussed. The goal is to deplete Putin’s financial reserves. That is remarkable, given the reliance the European Union (EU) has on Russia for its energy needs; Russia supplies roughly 27% of the EU’s crude oil and 38% of its natural gas.

Growth Slows
Real GDP is forecast to slow to a 1.4% pace in the first quarter, after surging 7% in the fourth quarter of 2021. Spending weakened after catching up in the wake of the Delta wave last summer, while home buying and building remained elevated. Business investment picked up but inventories were drained. Government spending rebounded but not as much as we had expected; schools were forced back online and delayed reopening during the Omicron wave. The trade deficit hit a new record, as backlogs at our docks started to be cleared and exports slowed with lockdowns abroad.

Real GDP is expected to rebound at a 2.5% pace in the second quarter. Spending is expected to pivot from goods to services as consumers scramble to travel. Home buying and building is expected to soften in response to higher mortgage rates. Business investment is expected to slow with the exception of the shale industry. Inventories are expected to be rebuilt. Government spending is expected to remain relatively weak, unless a large fiscal 2022 budget can be enacted. The trade deficit is expected to narrow slightly.

Fed Hits the Brakes. The Federal Reserve is expected raise rates seven times and reduce their balance sheet in 2022. What would stop the Fed from acting? A seizure in credit markets, which would precipitate a harder landing than a Fed-induced slowdown.

The geopolitical shift that is occurring is breathtaking. Even Germany, a deficit hawk, has promised to take on debt to boost defense spending, supply weapons to Ukrainian fighters and accelerate the pivot to renewables.

The challenge is to balance the push to diversify energy needs and more effectively stem climate change in a world where more oil and gas will be needed to offset the shortfall from Russia. Higher energy prices are among the most regressive of taxes; they hurt most those who can least afford them.

The crisis has triggered a rare moment of bipartisanship in Washington. Talks around the fiscal 2022 budget, which lapsed last October, were resumed. Increases in defense spending and some of the administration’s proposals are on the table, along with humanitarian aid for Ukrainian refugees. The UN estimated that more than a million had fled as of the writing of this report.

This edition of Economic Currents takes a closer look at how the conflict in Ukraine is likely to affect the U.S. economy. Special attention is devoted to the channels through which the crisis is likely to reach our economy, the risks of a more pernicious cycle of stagflation and how the Federal Reserve is likely to respond.

It will be hard for the Fed to avoid a semi-hard landing with growth slipping below the levels needed to keep unemployment from rising. Asurge in immigration, aided by an influx of refugees from Ukraine could help to avert such an outcome. The largest blow to labor supply over the last several years was a sharp drop in immigration.

Five Channels There are five channels through which we are most likely to feel the economic impacts of the Ukraine crisis:

  1. Higher inflation;
  2. Cyber attacks, designed to disrupt business and further muck up supply chains;
  3. Unity within NATO, which has reopened the door to fiscal stimulus;
  4. Financial market instability; and
  5. Additional rate hikes by the Federal Reserve.

Inflation/Stagflation Energy prices have risen in anticipation of lower supplies from Russia, which is the third largest producer of oil. Only Saudi Arabia and the U.S. produce more.

Grain prices have risen in response to the devastation Russia has wreaked on Ukraine. Ukraine is known as the breadbasket of Europe for its production of grain.

The timing couldn’t be worse, as it is adding fuel to an already well kindled inflation fire. The risk is that the inflation we are experiencing becomes more entrenched. Expectations about inflation have already moved up.

Why do expectations matter? Because they distort behaviors. They can trigger hoarding, which exacerbates the upward pressure on prices. In the extreme, they can change the demands of workers.

The latter is what occurred in the 1970s. Poor policy decisions by the Nixon administration, left us with years of higher inflation. Wage and price controls, the end of the Bretton Woods agreement and a sharp depreciation in the dollar stoked the the Vietnam era inflation. The former president also strong-armed the head of the Federal Reserve to stimulate for his 1972 reelection bid, despite higher inflation. (Much like Watergate, there are tapes.)

That erosion in purchasing power prompted unions to negotiate an annual cost of living adjustment (COLA) tied to the CPI in wage contracts. Those adjustments were quickly added to white-collar wage agreements to keep worker wages on a level playing field. That meant that an overwhelming majority of wages in the U.S. moved up in response to changes in inflation and then some.

Then, OPEC moved to embargo oil in October of 1973. Profit margins were squeezed as wages surged along with all other costs, which prompted firms to further raise prices and lay off workers. Inflation rose along with unemployment; the economy slipped into recession and a more vicious cycle of stagflation erupted.

The current situation bears an eerie resemblance to that period. There are no COLAs but wages in the service sector are rapidly raising costs. Profit margins for small and midsize firms are being squeezed, which is prompting more price hikes.

Fed Chairman Jay Powell has taken note. He repeatedly pointed to tight labor markets as inconsistent with the Fed’s goal of stable inflation, in his recent testimony to Congress. He even referred to labor markets as “overheated,” suggesting that rate hikes were needed to slow the pace of hiring.

That begs the question of whether rate hikes are also needed to increase the supply of workers via higher unemployment. There were 1.7 job openings for every person actively seeking work in December, a new record. The ranks of those looking for work continued to shrink during the first two months of 2022, while preliminary data revealed that job openings remained high.

Europe is more dependent on Russian oil exports and therefore more at risk for a recession and stagflation. The European Central Bank (ECB) is less inclined to raise rates than the Fed; that risks a more vicious cycle of rising inflation and higher unemployment.

Cyber Attacks Cyber attacks have already accelerated and are designed to disrupt business. Toyota was forced to shut all 14 of its plants in Japan for 24 hours after a cyber attack on one of its suppliers on March 1.

It is not known whether the attack was related to the war in Ukraine. It occurred after Japan joined Western allies in sanctions against Russia. The risk is that cyber attacks could further muck up supply chains.

Other targets could include financial institutions, the energy grid and government institutions. Anything that will disrupt the course of business is possible as the conflict wears on, although there is no intelligence on specific targets. Counterattacks are also underway.

Fiscal Stimulus The surge in geopolitical tensions triggered by Russia reopened the door to more stimulative fiscal policy. Members of Congress are scrambling to agree on add-ons before the March 11 funding deadline for the fiscal year 2022. Until they do, it is difficult to gauge how additional funds will be spent during what is left of the fiscal year that ends in September.

“(The 1970s are) the proper historical reference for what we at the Fed are trying to avoid.” —   Federal Reserve Chairman
Jay Powell, March 2, 2022
Defense spending tends to be more inflationary than other forms of spending. Historically, defense contracts were larger and more littered with waste than other government contracts. There is no way to gauge how much Congress decides it can get out the door by the end of the current fiscal year in September.

The bulk of the buildup in defense spending is not expected to show up until 2023 and 2024. Congress actually passed a stand-alone defense bill for fiscal 2022, which is expected to be revisited.

Humanitarian aid for Ukrainian refugees and weapons for Ukrainian fighters are sent abroad. Hence, that spending is less of an issue for the domestic economy.

Financial Market Instability So far, financial markets have weathered the storm triggered by Putin’s invasion relatively well but that does not rule out some sort of a credit market seizure. The Federal Reserve still has the emergency facilities it put in place at the onset of the pandemic in March 2020. Some facilities were never used; just knowing they were available kept markets functioning.

The probability that Russia could default on its debt surged above 50% as sanctions on its central bank were imposed. Other developing economies are at risk.

Many loaded up on debt to blunt the blow of the pandemic and may be forced to raise rates to defend their currency. The flight to safety of the U.S. Treasury market and related appreciation of the U.S. dollar is intensifying that pressure.

Rate hikes and balance sheet reductions by the Fed will exaserbate the pressure to raise rates and defend currencies in developing economies. Powell must walk a tightrope, balancing rate hikes with the need to avoid a larger pullback in credit markets. AFed-induced recession is much easier to recover from than a credit crisis; 2008 and 2009 taught us that.

Additional Rate Hikes The Fed has estimated that the neutral level for short-term rates - the rate that does not raise unemployment or stoke inflation - is somewhere between 2 and 2.5%. That is a lot of rate hikes from where we are today.

Powell said that he was on board with a quarter point rate hike in March but couldn’t rule out a half percent hike at subsequent meetings. The Fed is now expected to raise rates seven times in 2022 and three more times in 2023. That is a half percent more than we forecast a month ago; all additional gains are front-loaded.

The Fed is expected to announce a reduction in its balance sheet at the June meeting. There seems to be a consensus forming around $100 billion per month. The Fed would prefer to hold Treasury bonds instead of mortgage-backed securities (MBS).

Chart 1

Economic weaknes front loaded

Some Fed Presidents have supported selling MBS to reduce the Fed’s holdings more rapidly. That has already widened the spread between the 10-year Treasury bond and mortgage rates. There is no precedent for raising rates and reducing the Fed’s balance sheet simultaneously. Beware unintended consequences.

Weaker Growth, Hotter Inflation Charts 1 and 2 lay out the effects of those shifts on the U.S. economy. Growth is expected to slow much more rapidly. Inflation is expected to remain hotter for longer than we expected just a month ago.

The forecast assumes a short-lived conflict, with oil prices staying above $100 per barrel through mid-2022. The situation is fluid; the conflict could drag on.

Consumer spending is expected to stall in the second half of the year, after picking up in the second quarter. Large backlogs will soften the blow but are expected to be quickly depleted.

Home buying and building are forecast to fall in response to higher mortgage rates. Skyrocketing prices and a surge in investors, who can pay cash, have crowded out first-time buyers.

Chart 2

Inflation hotter for longer

Business investment will slow, although we are expecting a temporary bump in investment in the shale industry. Smaller producers have begun to increase rig counts. Larger producers are expected to boost production in the second half of 2022.

Gains in state and local government spending are expected to offset the slowdown in federal spending. The extra bump in federal spending due to Congress’ kumbaya moment is still a pipe dream. I will believe it when I see it.

The trade deficit is expected to narrow after widening dramatically in the first quarter of this year. Trade flows to and from the U.S. are expected to weaken.

Risks. A more prolonged conflict could boost oil prices further and trigger a full-blown recession. It would take a much larger move up in oil prices, such as $125 per barrel sustained through the third quarter, and rate hikes by the Fed to trigger a recession.

There is also the nuclear option, which Putin has threatened. I really just can’t go there. Suffice it to say, our economy may become the least of our concerns.

Bottom Line Powell was asked if the 1970s were a good benchmark for the current environment during his testimony. He replied, “That’s the proper historical reference for what we at the Fed are trying to avoid.”

It is important that the 1970s are on the Fed’s radar. It is easier to avoid a threat you understand.

On a more positive note, the world has shown a shocking level of unity in defense of democratic freedoms in recent weeks. Many a skyline, including my hometown of Chicago, is lit with blue and yellow lights to show our support of the Ukrainian people and their fight.

I found myself searching for sunflowers, the flower of Ukraine, to show that I too stand with the Ukrainian people. Their defiance has inspired and provided a glimmer of hope for a badly battered world.

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