Escalating sanctions by the West to punish Russia for its war against Ukraine are driving fears that an episode of increased inflation, already at its highest levels in 40 years, will become harder to wring out of the U.S. economy without a recession.
Before Moscow’s invasion three weeks ago, Federal Reserve Chairman Jerome Powell had begun laying the groundwork for a more aggressive series of rate increases, driven by concerns that labor markets were overheating. He and his colleagues were also banking on getting an assist from recovering supply chains later this year, limiting how far rates would have to rise.
Now, the global economy faces the prospect of higher energy and commodity prices, which will raise the costs to transport and manufacture a range of goods, while the conflict further disrupts global shipping networks. “The war makes inflation more intractable,” said Steven Blitz, chief U.S. economist at TS Lombard, a research firm.
The threat is unlikely to alter what the Fed does at its meeting this week. Mr. Powell said earlier this month that the central bank wants to avoid adding to volatility at a time when geopolitical uncertainty has already raised the risk of a sharp pullback in risk-taking by investors.
He signaled that the Fed would kick off an expected series of rate rises this week with a quarter-percentage-point increase, rather than a half-point, which a few Fed officials had floated and some investors had said would be appropriate. But he hinted that a series of shocks, including the Russian invasion, could keep inflation uncomfortably high, potentially calling for larger rate rises this summer.
Economists say there’s a growing risk that Mr. Powell could feel great pressure to lift rates to levels that ultimately tip the economy into recession. “It’s a very difficult path for the Fed to guide inflation back to target without triggering a downturn, and the path got even narrower with this latest supply-side shock we’re seeing,” said Matthew Luzzetti, chief U.S. economist at Deutsche Bank.
Renewed pandemic lockdowns in China in recent days are adding even more disruptions to the battered supply chain.
The inflation threat for the Fed is twofold. The first risk is that the surge in prices could become intense enough or last long enough to change consumers’ and businesses’ inflation psychology, making those expectations self-fulling. If workers anticipate a robust inflation rate in a year’s time, they will be more likely to push for higher wages now.
The second risk is that a tight labor market, with demand for workers far outstripping the supply, generates wage growth that keeps inflation above the Fed’s 2% target.
Those two forces threaten to ignite an inflationary spiral, where workers face higher prices and demand more pay, leading businesses to continue raising prices. “If this inflation is going to last in a problematic way, that has to be the mechanism,” said David Mericle, chief U.S. economist at Goldman Sachs. He now expects core inflation, which excludes food and energy, using the Fed’s preferred gauge, of 3.7% this year, versus an earlier forecast of 3.1%. It was 5.2% in Januar
Even before the war, business executives had planned to keep raising prices this year, after disrupted supply chains collided with strong consumer demand, sending inflation rising.
“We went into this year across our entire portfolio—without this conflict in mind—knowing that we were facing commodity price increases [and] shortages. So we had a very healthy level of inflation or cost increases built into our plan. That’s probably gotten a little steeper over the last couple of days,” said Joseph Wolk, chief financial officer at Johnson & Johnson, at an investment conference last week.