BACK TO THE BOUTIQUE INVESTOR BLOG The Russia Shock and its Potential Effect on Fed Policy William Sterling, Ph.D. 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 16th, 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. For more information, read the full report here at GW&K’s Global Perspectives Past performance is not a guarantee of future results. Investing involves risk including possible loss of principal. This does not constitute investment advice or an investment recommendation. Any securities discussed herein do not represent the entire portfolio and in aggregate may represent only a small percentage of a portfolio’s holdings, or, may not be held in an account’s portfolio at all. It should not be assumed that any of the securities transactions discussed were or will prove to be profitable, or that the investment recommendations we make in the future will be profitable or will equal the investment performance of any security discussed herein. This represents the views and opinions of GW&K Investment Management. It does not constitute investment advice or an offer or solicitation to purchase or sell any security and is subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes.