FINANCIAL NEWS HIGHLIGHTS OF THE WEEK
- The Russian invasion of Ukraine shook markets this week with the S&P 500 entering correction territory before making gains Friday. Given Russia’s role as a key global energy producer, market concerns about supplies have driven prices for oil and natural gas higher.
- For the U.S., the most immediate impact will come from higher oil prices, which will keep inflation elevated and weigh on growth. The impact will depend on how long the conflict lasts.
- Barring severe market disruption, we still expect the Fed to hike rates in March. The core PCE deflator reached 5.2% year-on-year in January, underscoring that the Fed is behind the curve on inflation and can’t wait for the perfect time to hike.
U.S. -All About Inflation and Geopolitics
Regrettably, Russia made risk reality this week, launching an all-out invasion of Ukraine in geopolitical and financial news. The threat of Russian military aggression had been souring market sentiment for several weeks now, and the invasion worsened declines in equity markets and sent energy prices higher (Chart 1). The S&P 500 entered correction territory this week, relative to its early January highs, and was down 0.2% at time of writing versus a week ago. With Russia’s role as a key global energy supplier, worries about energy supply have driven prices for oil and natural gas higher. The Brent crude benchmark crossed the $100 per barrel threshold for the first time since 2014.
Market selloffs at the outset of wars have historically been short and reversed quickly. That said, there is still likely to be an economic toll on global growth from the conflict, with Europe likely to take the biggest hit. The outcome depends on how long the conflict goes on, and market reaction. We outlined some potential scenarios in our recent report Questions? We’ve Got Answers.
For the U.S., the most immediate impact will come from higher oil prices. These will keep inflation elevated and weigh on purchasing power longer than previously expected. We expect prices to ease as the conflict does, but how long it lasts is highly uncertain. The West Texas Intermediate oil price is around $92 per barrel at time of writing, up over 20% from the start of the year. If it were to remain above $90 per barrel for the remained of the year, it would shave a few tenths off of real GDP growth in 2022. We are currently tracking real GDP to grow of 2.8% in 2022 (Q4/Q4), so a slightly softer pace would still be a solid pace for growth.
The conflict in Europe comes just three weeks ahead of what is widely expected to be the Federal Reserve’s first interest rate hike. The war is unlikely to prevent the Fed from taking its policy rate off the floor. At 0.5%, the federal funds rate will remain highly stimulative. The Fed is behind the curve on inflation and can no longer wait for the perfect moment to begin normalizing policy.
On that front, the core personal consumption expenditure (PCE) deflator – the Fed’s preferred indicator – was up 5.2% in January, the fastest rate in nearly 40 years. While a bit lower than the 6% increase in the core CPI, it is still a lot higher than the Fed would like. Monetary policy works with a lag and rate hikes this year will not do much to reduce inflation until next year. In the meantime, a lot has to go right to slow inflation’s roll. This increases the urgency to raise rates now or risk unmooring expectations and having to hurt the economy more later in order to rein them back in.
One piece of good financial news this week was a solid rebound in consumer spending in January (Chart 2). The rebound was driven by durable goods, led by spending on vehicles. Spending on close contact services weakened, showing the impact of consumer caution as Covid cases rose. We expect these categories to rebound in February and March, with the high-frequency data already showing that consumers are returning to restaurants and air travel.
Leslie Preston, Director | 416-983-7053
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