The Russia Shock and its Potential Effect on Fed Policy

William Sterling, Ph.D.

GLOBAL STRATEGIST | GW&K INVESTMENT MANAGEMENT

As the tragic human consequences of Russia’s aggressive invasion of Ukraine unfold, we can only guess at the intermediate and longer-term economic and financial market implications.

During his semiannual testimony to Congress in March, Fed Chair Jerome Powell described the Russian invasion as a “game-changer” that could have long-lived effects. Powell was careful to note that it is too early to say what the real effects will be on the economy. He further recognized the uncertainty that developments in Ukraine have created and the need “to be nimble in responding to incoming data and the evolving outlook.”

Even before geopolitical events ratcheted up, Powell acknowledged that he envisioned a policy path this year in which every FOMC meeting was a possibility for a rate hike and that the Fed would also make progress toward shrinking its balance sheet. In short, by sticking with the basic plan that had evolved before the Russian invasion, the Fed is attempting “to avoid adding uncertainty to what is already an extraordinarily challenging and uncertain moment.”

In general, higher inflation pressures require the Fed to be more aggressive in raising rates and also in risking recessions to curb inflation pressures.

Given Powell’s framing of the Russia shock and his intention to get inflation “back under control,” it is worth looking at the history of Fed rate-hiking cycles to get a sense of how financial markets have historically responded. Looking back at periods when geopolitical uncertainty intersected with high inflation and Fed tightening can give us clues on what to expect in the current environment.

Note: Four highest inflation periods shaded in red: 1947, 1974, 1977, 1980; four lowest inflation periods shaded in blue: 1954, 1961, 1999, 2015

*Treasury bill discount rate used before 1954 Source: GW&K Investment Management, Federal Reserve, and Macrobond

As shown in the table above, there have been 17 rate hiking cycles since World War II. We can see that the average cycle lasted about two years (27 months) and saw an increase in the federal funds rate of about 4%. In general, higher inflation pressures require the Fed to be more aggressive in raising rates and also in risking recessions to curb inflation pressures.

Powell was very clear that he thought it was appropriate to begin raising interest rates at its March policy-making meeting amid high inflation, strong economic demand, and a tight labor market. The Fed indeed did raise the federal funds rate by 25 basis points on March 16^th, and did not rule out moving more aggressively at a “meeting or meetings” beyond that if price increases come in higher than expected or persist longer than expected.

Although developments in Ukraine remain in a state of rapid flux, the invasion is likely to go down in history as a major geopolitical shock.

By continuing to emphasize flexibility and a focus on incoming data, the Fed Chair has left the door open to a more aggressive policy if necessary and to implement additional rate hikes more slowly if it turns out that geopolitical factors are dampening economic activity.

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