To Hike or Not To Hike?
To hike or not to hike? That is the question. While Russia’s invasion of Ukraine is first and foremost a humanitarian crisis, it has also made what was once a clear decision for global central banks to tighten monetary policy much more nuanced. Although inflation is rising and labor markets are tight, central bankers now have to grapple with how the war impacts growth and the consumer, specifically as result of surging commodities prices.
Even before Russia invaded Ukraine, commodity inventories were low, and without inventories to cushion a supply/demand imbalance, we could expect larger-than-normal price volatility. This is exactly what happened in 2021: the Bloomberg Commodity (BCOM) index had its best year since 1979, returning 27% . In 2022, however, markets have become completely unglued. Through March 8th, the BCOM Index has already risen 35% with oil, wheat, and nickel up 65%, 65%, and 130% respectively1!
In essence, any commodity that Russia produces in scale has seen an unprecedented price surge due to the immense uncertainty surrounding the supply outlook. At the moment, the West has not explicitly sanctioned energy transactions, but crude sourced from Russia is trading at a significant discount, suggesting companies are stepping away on their own accord. Furthermore, countries are starting to implement full-fledged import/export bans across a range of commodities. As a result, it is unlikely that supply chains will function the same way they did before the invasion, and it is unclear when or how this will be resolved.
To understand how central banks might react, we must analyze the effect of rising commodities prices on individual economies. The Eurozone, for example, is heavily reliant on Russian oil and gas. Germany, the continent’s largest economy, imports 50% of its natural gas from Russia, and thus is most exposed to any supply disruptions. The UK imports none from Russia, but relies on natural gas for over 40%2 of its energy production, more than any country in Europe, and would also be exposed to a shock in prices via higher heating bills, or more acutely if there is downstream demand destruction. Canada and the US, on the other hand, are more insulated. Canada runs an energy trade surplus and the US is roughly flat2, so the impact will mainly be felt via higher gasoline prices, which crowds out other spending.
Despite the high level of uncertainty, we can begin to cobble together a framework to help answer the question: to hike or not to hike? In Europe, despite rising employment, wages, and inflation that has the market forecasting two rate hikes in 2022, the ECB may be forced to move more slowly. Exposure to Russia varies by country, but sustained high energy prices will negatively impact growth across the continent, and a severe supply disruption may even push Europe into a recession.
In the UK, the market is more confident in rate hikes, pricing in a policy path that reaches 1.90% (8 total hikes) by year end. While they run a smaller commodity trade deficit compared to the rest of Europe, with natural gas prices up 1000% year-over-year, it seems it’s more a matter of when, not if, this impacts the consumer.
Like the Bank of England, the Federal Reserve (Fed) desperately wants to reset policy to a more normal level and is poised to hike 25 bps this month. The Fed will closely monitor the situation in Ukraine, but the US is much more insulated to an energy shock than Europe, and unless the conflict materially knocks the US economy off its above-trend growth rate, they will feel comfortable hiking rates multiple times this year and beginning the balance sheet runoff this summer.
Taking this all together, it’s impossible to know with much certainty how central banks will balance these competing forces since the news flow out of Ukraine is changing by the minute. But we can still arrive at some high-level conclusions:
- Inflation will peak later and higher than previously expected; we could potentially see headline CPI above 8% in the US and 7.5% in the Eurozone. Furthermore, while central bankers may look through supply-driven food and energy shocks via core inflation, it’s possible that further disruptions in an already shaky supply chain sustains the upward pressure on core goods and risks de-anchoring inflation expectations. Therefore, the probability of stagflation and/or recession should be higher, though how high this probability gets will be driven by the duration and magnitude of the commodity shock.
- The probability of fiscal stimulus, particularly in Europe has increased. The European Union could issue joint debt to fund spending on defense and projects to reduce reliance on Russian gas, as well as potentially further subsidizing energy prices. Should gasoline prices spike in the US, the White House could implement spending policies to incentivize shale production or alleviate the burden on the consumer. Similar to the Covid-19 response, targeted fiscal stimulus could result in additional inflation pressure and result in the need for tighter monetary policy, putting further upward pressure on front-end rates.
- The global synchrony story where all central banks are hiking in unison looks shakier than it did one month ago, and this could prevent back-end yields from rising much further. Should European growth slow, it’s quite possible the Fed finds itself in a similar situation to the 2016-2018 cycle, where it was hiking alone and financial conditions were tightened primarily via a strong USD.
- Ultimately, the path of tightening is no longer clear cut, and in hindsight global central banks probably wished they started sooner. Looking forward, they will need to be nimble and forthcoming, though the odds of central banks’ successfully achieving a “soft landing” by balancing rising inflation and slowing growth have declined.
2Source: J.P. Morgan Asset Management
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