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War in Europe Exacerbates Inflation, Posing a Challenge for the Fed

Policymakers May Have To Slow Planned Rate Hikes To Avoid Recession

By Christine Cooper and Rafael De Anda CoStar Analytics

March 16, 2022 | 6:35 AM

The consumer price index has seen annual gains of more than 4% for 10 consecutive months. Early during that period, slightly higher inflation was explained by the disinflationary environment created in March and April of 2020, when almost 22 million workers were laid off, as well as by disruptions in the supply chain and transportation lines caused by the pandemic. The so-called base effects lasted just a few months because inflation persisted and grew.

Consumption patterns shifted toward goods as people were hunkered down at home early in the pandemic and away from services that were largely restricted. That reallocation of demand and the difficulties factories had in meeting that demand led to large price increases of several items, such as automobiles, home fitness equipment and outdoor recreational items. This driver of inflation was expected to be transitory — with inflation fading alongside fiscal stimulus.

But supply chain bottlenecks and shortages of some items — notably semiconductors — have persisted. Deliveries of component items in addition to finished goods still face delays due to port congestion and fewer truck drivers, while manufacturers overseas frequently have had to halt operations entirely due to zero-tolerance policies during the many COVID flare-ups around the world.

Still, many of these drivers of inflation should be ending soon. New COVID cases are slowing almost everywhere, and domestic spending is starting to shift back to services. That would support notions of inflation peaking shortly, after reaching a four-decade-high pace in February, when the consumer price index grew by 7.9% over the year, as reported by the Bureau of Labor Statistics.

There has been a change in inflation from earlier in the recovery. A year ago, it was mostly vehicle costs that were driving inflation, as the global shortage of semiconductors limited automobile production and it became tougher to find a rental car after rental agencies sold off much of their inventory while the coronavirus deterred people from traveling.

But now prices are rising for lots of everyday items, including food and shelter, which have both seen large year-over-year gains.

Earlier in the year, the Federal Reserve announced its intention to address hot inflation by lifting its overnight lending rate, giving market participants plenty of time to digest the news. Up until most recently, the Fed was expected to raise rates by 25 basis points at each of its meetings for the rest of the year, raising borrowing costs in the hopes of cooling demand and bringing down the rate of inflation before it becomes entrenched.

But Russia’s escalating war in Ukraine may be complicating the Fed’s plans. Much of Europe relies heavily on the two energy-rich countries for electricity, natural gas and oil. Since the invasion began, global commodity prices have spiked, which will cause higher consumer prices in the U.S.

Natural gas has seen the sharpest price hikes, but the impact of that has been mostly constrained to European economies. For the U.S., though, the price volatility of oil is almost immediately transmitted to higher prices at the pump. Already up 11% over the prior month before the war began — based on the first purchase price of a U.S. blend of crude known as West Texas Intermediate — the price of crude oil rose from roughly $93 on Feb. 24 to $124 on March 8, but has since receded.

Gasoline is not a major component of consumer spending, accounting for less than 5% of household budgets, but higher gas prices can have an outsize influence on the consumer psyche. Consumer expectations for what inflation will be in 12 months ticked higher to 6% in February from 5.8% in January, while expectations for inflation three years in the future rose to 3.8% from 3.5%. Inflation could last longer and remain elevated if expectations remain anchored at these high levels.

Neither Russia nor Ukraine is a large U.S. trading partner, but many European countries are, and sharply rising prices of energy and other types of commodities, such as wheat, corn, fertilizers and metals, could slow economic activity in Europe and around the world, weighing on U.S. exports and creating a drag on economic growth.

The inflation impacts of the war have not yet made their way into the consumer price index, so next month’s reading is sure to be even higher.

In the end, whether it’s energy prices or the cost of food or even cars, consumers are feeling the pinch and sentiment is cratering. Falling consumer sentiment will lead to a pullback in spending, which essentially is what the Fed is hoping for, at least to take some of the froth out of the market. But the combination of escalating energy prices, slowing consumer demand and a slowdown in U.S. economic activity as Europe falters amid the war can draw the speed of the economy down more quickly than anyone would want, tipping us into recession.

As a result, the Fed may slow its pace of tightening to prevent that from happening.

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